What is a 'Collar'
A collar is a protective options strategy that is implemented after a long position in a stock has experienced substantial gains. An investor can create a collar position by purchasing an out-of-the-money put option while he simultaneously writes an out-of-the-money call option. A collar is also known as hedge wrapper.
BREAKING DOWN 'Collar'A collar may also describe a general restriction on market activities. An example of a collar in market activities is a circuit breaker that is meant to prevent extreme losses (or gains) once an index reaches a certain level. However, the term "collar" is more often used in options trading to describe the position of being long put options, short call options and long shares of the underlying stock.
Collar Strategy Mechanics
The purchase of an out-of-the-money put option is what protects the underlying shares from a large downward move and locks in the profit. The price paid to buy the puts is lowered by amount of premium that is collected by selling the out-of-the-money call. The ultimate goal of this position is that the underlying stock continues to rise until the written strike is reached. Collars can protect investors against massive losses, but collars also prevent massive gains.
The protective collar strategy involves two strategies known as a protective put and covered call. A protective put, or married put, involves being long a put option and long the underlying security. A covered call, or buy/write, involves being long the underlying security and short a call option.
Maximum Profit and Loss
If the strategy is implemented for a debit, the maximum profit of a collar is equivalent to the call option's strike price less the underlying stock's purchase price per share less the net premium paid. Conversely, if the trade is implemented for a credit, the maximum profit may could also be equivalent to the call strike less the underlying stock's purchase price plus the net credit received.
The maximum loss is equivalent to the purchase price of the underlying stock less the put option's strike price and the net premium paid. It may also be equivalent to the stock purchase price less the put option's strike price plus the net credit received.
Assume an investor is long 1,000 shares of stock ABC at a price of $50 per share, and the stock is currently trading at $47 per share. The investor wants to temporarily hedge the position due to the increase in the overall market's volatility. Therefore, the investor purchases 10 put options with a strike price of $45 and writes 10 call options with a strike price of $60. Assume he options positions are implemented for a debit of $1.50. The maximum profit is $11,500, or 10 * 100 * ($60 - $50 + $1.50). Conversely, the maximum loss is $6,500, or 10 * 100 * ($50 - $45 + $1.50).