What Is a Collar Agreement?
Generically, a "collar" is a popular financial strategy to limit an uncertain variable's potential outcomes to an acceptable range or band. In business and investments, a collar agreement is a common technique to "hedge" risks or lock-in a given range of possible return outcomes. The biggest drawback to a collar is limited upside and the cost drag of transaction expenses. But for certain strategies, a collar acting as an insurance policy more than overcomes the additional fees.
Effectively, a collar sets a ceiling and a floor for a range of values: interest rates, market value adjustments, and risk levels. With the many securities, derivatives, options, and futures now available, there's no limit to a collar potential.
Collar Agreement Explained
For equity securities, a collar agreement establishes a range of prices within which a stock will be valued or a range of share quantities that will be offered to assure the buyer and seller of getting the deals they expect. The primary types of collars are fixed-value collars and fixed share collars.
A collar may also include an arrangement in a merger and acquisition deal that protects the buyer from significant fluctuations in the stock's price, between the time the merger begins and the time the merger is complete. Collar agreements are utilized when mergers are financed with stock rather than cash, which can be subject to significant changes in the stock's price and affect the value of the deal to the buyer and seller.
Perhaps the flashiest collar of all is used with options strategies. Here, a collar includes a long position in an underlying stock with the simultaneous purchase of protective puts and the sale of call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal to the number of contracts. Technically, this collar strategy is equivalent to an out-of-the-money covered call strategy with the purchase of an additional protective put. This strategy is popular when an options trader likes to generate premium income from writing covered calls but wishes to protect the downside from an unexpectedly sharp drop in the price of the underlying security.