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.
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.