Add Protection Against a Bear Market With Collar Options

When bears grab a hold of the market and volatility is the order of the day, most investors either suffer significant losses or get shaken out of what eventually become profitable positions. This can leave rookie investors frustrated and fearful of re-entering the market. An options strategy known as the collar can help relieve some of the angst of investing during turbulent times.

Most investors that are familiar with options know about the basics of purchasing puts and calls. This is a good starting point for the more advanced concept of collars, though collars should not be viewed as intimidating. Rather, they can serve as vital protection for your portfolio during a bear market and prevent you from hastily exiting a trade.

The primary benefit of a collar is that it limits downside risk. That is a nice security blanket, but since we can't get something for nothing, collars also limit profits on the upside, hence why they are used mainly during down markets.

This is how collars work: The investor has a long position in a stock (wants his shares to rise) and buys a put option and sells (or writes) a call option. The strike price for the call, or price at which it is profitable, needs to be above that of the put and the expiration dates for both the purchased put and sold call need to be the same.

Say we own 100 shares of Company XYZ at $45. To implement a proper collar, we would buy one put with a strike price of $43 and sell a call with a strike price of $47 that expire at the same time. As a rule of thumb, for every 100 shares of Company XYZ that you own, you'll want to buy one put and sell one call. The collar ensures we can't lose or make more than $2 on the trade no matter how high XYZ rises or how low it falls.

If XYZ rises above $47, the person who bought our call will exercise his option and we sell him the shares at $47, meaning we make a $2 profit. If Company XYZ falls below $43, then we only lose $2. When expiration date rolls around and XYZ is trading between $43 and $47, the options expire worthless and we still have our shares worth whatever they're trading at that time.

It is important to remember that a protective put, which is the type we buy with a collar, can be expensive during volatile markets and the cost of purchase can dilute upside potential. This is why investors need to fully execute the collar and remember to sell the call as well.

Collars are a neutral strategy, and as we have noted, their primary objectives are capital preservation and limiting risk, not generating profits. That being said, we can earn a small profit on the difference in strike prices minus the cost of buying the put. For example, if the calls we sold were trading at $1.20, we would earn $120 for selling that contract. (One contract = 100 shares x $1.20 = $120). If the puts were selling for $1.10 our cost would be $110. (One contract = 100 shares x $1.10 = $110). And there we have a $10 credit to our account to start.

Another way to generate a little extra cash would be to sell a call that is “at the money” meaning the stock is currently trading at the strike price of the call. This strategy garners a higher premium, but limits upside potential. On the other hand, upside potential is expanded by selling an out of the money call, but a smaller premium is collected.

The reality is collars simply don't possess the power to generate profits as significantly as other options strategies. That is why the prudent investor exploits the benefits of collars in a bear market. Think of the collar as a “preserve-and-protect” tool when opportunities for capital appreciation are either too risky or hard to find.

Collars are a conservative strategy, to be sure, and one that is generally implemented to protect profits, not generate them. Investors need to always be assessing the risk/reward ratio of every position they're considering. Fortunately, the risk/reward scenario for collars is clear: It's low risk, low reward. Obviously, collars aren't for everyone. If you're the type of investor that thrives on volatility and enjoys a little bit of risk, collars definitely aren't your game.

On the other hand, if violent moves in the market make you sweat bullets, or you have some trepidation about an upcoming earnings announcement or Federal Reserve action, collars are a fine way to protect your portfolio from the unexpected.

What's even better than earning rewards for spending on your credit cards? Getting paid hundreds of dollars worth in sign-up bonuses in three months or sooner -- just for trying out a new card.Wh...
Tired of dragging credit card debt around with you? Taking 15 minutes to transfer your debt to a credit card with generous balance transfer perks could save you thousands in interest charges and ...
If you're going to spend money anyway, then why not get paid for it?Whether you're looking for credit cards with up to 6% cash back, double flight miles, or even a free hotel stay each year, ther...
by Christian HudspethIn times where interest rates are on the rise, you may start hearing financial advisors and bankers sing the praises of an income strategy called "CD laddering" (short for ce...
Those of us familiar with selling property know real estate agents don't come cheap. With real estate agent commission and fees amounting to as much as 6% of the selling price (that's $18...
Beverly Harzog is a nationally recognized credit card expert, author, and consumer advocate. She blogs about credit cards at BeverlyHarzog.com. Being in credit card debt is the pits. I've bee...
If you haven't already felt the pressure to refinance your mortgage, you're probably really feeling it now. Mortgage rates are still hovering near historic lows. But with the economy improving...
If you or someone you know is thinking about getting a home mortgage, you may want to know about the thousands of dollars in hidden charges that some lenders are quietly adding to mortgage loans ...
by Christian Hudspeth Money market accounts (MMAs) and savings accounts make great places to set aside your emergency fund money and earn some interest income at the same time.Simply put, these s...
by Christian Hudspeth It's true that auto loans and home loans offer attractively-low annual percentage rates (APRs), while credit cards offer borrowing power without the risk of ever seeing the ...
by Christian HudspethWant to keep your emergency fund safe while earning interest yields that are three to five times higher than a typical savings account? Putting your money into an FDIC-insure...
Question: Hi there. I need your advice. I'm only 19 and I really need to start investing. Where can I start? -- Tirelo M., Gaborone, Botswana Answer: You've definitely got the right thinkin...