What is a Collar
Collar option strategies are a protective strategy that is implemented on a long stock position. An investor can create a collar position by purchasing an out-of-the-money put option while simultaneously writing an out-of-the-money call option. A collar is also known as hedge wrapper. The put protects the trader in case the price of the stock drops. Writing the call produces income (or offsets 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.
Breaking Down the Collar
Collars, in option trading, describe the position of being long put options, short call options, and long shares of the underlying stock. The call and put should be the same expiry month and the same number of contracts. The strike prices of the call and put are different. 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 strategy is used by traders who are mildly bullish, but who also want to protect against a downside move in the stock. They are also willing to give up gains on the stock above the strike price. Therefore, this strategy is not typically used by traders who are very bullish and expect a large price increase.
Collar Strategy Mechanics
The purchase of an out-of-the-money put option is what protects the trader from a large downward move in the stock price. The price paid to buy the puts is reduced by amount of premium that is collected by selling the out-of-the-money call.
Collars protect investors against big losses, but collars also prevent big gains because the upside in the stock is limited to the strike price of the call written call option.
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
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 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.
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.
The investor purchases 10 put options with a strike price of $45 and writes 10 call options with a strike price of $60.
Assume the option positions are implemented for a debit of $1.50, meaning the two option positions costs $1.50 total (per share) to put on.
The maximum profit is $8,500, or 10 contracts x 100 shares x ($60 - $50 - $1.50). This scenario occurs if the stock prices goes to $60 or above.
Conversely, the maximum loss is $6,500, or 10 x 100 x ($50 - $45 + $1.50). This scenario occurs if the stock price drops to $45 or below.