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Collar refers to a protective options strategy that investors use after a stock has experienced substantial gains.

Investors who implement a collar strategy are typically bullish but cautious. They believe the stock will rise further and aren’t ready to sell it yet, but they want to hedge against a potential drop in value.

For example, Sam owns 50 shares of ABC Corporation at $50 a share. Sam buys a protective put with a strike price of $47, and sells a covered call with a strike price of $55. Both options have the same expiration date.

If the stock rises above $55 at the expiration date, Sam will be forced to sell his shares, and should be prepared for that possibility. He will earn $5 per share. If the stock falls below $47 at expiration, Sam loses $3 per share, but no more. He has bought the right to sell those shares at $47 each even if they fall much further. If ABC continues to trade between $47 and $55, both options expire worthless and Sam retains his shares. If he used the profits from selling the call to buy the put, his expenses should be minimal.

Essentially, a collar is an insurance policy for a stock that has grown in value. It’s a low-cost way to protect gains and hedge against downside risk. The tradeoff is by using a collar strategy, an investor limits upside potential. The strategy is also known as a hedge wrapper.

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