The Collar Options Strategy Explained in Simple Terms

What Is a Collar?

A collar, also known as a hedge wrapper or risk-reversal, is an options strategy implemented to protect against large losses, but it also limits large gains.

An investor who is already long the underlying creates a collar by buying an out-of-the-money put option while simultaneously writing an out-of-the-money call option. The put protects the trader in case the price of the stock drops. Writing the call produces income (which ideally should offset the cost of buying the put) and allows the trader to profit on the stock up to the strike price of the call, but not higher.

Understanding a Collar

An investor should consider executing a collar if they are currently long a stock that has substantial unrealized gains. Additionally, the investor might also consider it if they are bullish on the stock over the long term, but are unsure of shorter-term prospects. To protect gains against a downside move in the stock, they can implement the collar option strategy. An investor's best-case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.

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.

The purchase of an out-of-the-money put option is what protects the trader from a potentially large downward move in the stock price while the writing (selling) of an out-of-the-money call option generates premiums that, ideally, should offset the premiums paid to buy the put.

The call and put should be the same expiry month and the same number of contracts. The purchased put should have a strike price below the current market price of the stock. The written call should have a strike price above the current market price of the stock. The trade should be set up for little or zero out-of-pocket cost if the investor selects the respective strike prices that are equidistant from the current price of the owned stock.

Since they are willing to risk sacrificing gains on the stock above the covered call's strike price, this is not a strategy for an investor who is extremely bullish on the stock.

Collar Break Even Point (BEP) and Profit Loss (P/L)

An investor's breakeven point (BEP) on a collar strategy is the net of the premiums paid and received for the put and call subtracted from or added to the purchase price of the underlying stock depending on whether there is a credit or debit. Net credit is when the premiums received are greater than the premiums paid and net debit is when the premiums paid are greater than the premiums received.

The maximum profit of a collar is equivalent to the call option's strike price less the underlying stock's purchase price per share. The cost of the options, whether for a net debit or credit, is then factored in. The maximum loss is the purchase price of the underlying stock less the put option's strike price. The cost of the option is then factored in.

• Maximum Profit = (Call option strike price - Net of Put / Call premiums) - Stock purchase price
• Maximum Loss = Stock purchase price - (Put option strike price - Net of Put / Call premiums)

Collar Example

Assume an investor is long 1,000 shares of stock ABC at a price of $80 per share, and the stock is currently trading at $87 per share. The investor wants to temporarily hedge the position due to the increase in the overall market's volatility.

The investor purchases 10 put options (one option contract is 100 shares) with a strike price of $77 and a premium of $3.00 and writes 10 call options with a strike price of $97 with a premium of $4.50.

• Cost to implement collar (Buy $77 strike Put & write $97 strike call) is a net credit of $1.50 / share.
• Breakeven point = $80 + $1.50 = $81.50 / share.

The maximum profit is $15,500, or 10 contracts x 100 shares x (($97 - $1.50) - $80). This scenario occurs if the stock prices goes to $97 or above.

Conversely, the maximum loss is $4,500, or 10 x 100 x ($80 - ($77 - $1.50)). This scenario occurs if the stock price drops to $77 or below.