An options strategy known as a stock option collar
, or simply a collar
, can help relieve some of the angst of investing
during turbulent times. When bears grab a hold of the market
and volatility is the order of the day, many investors either suffer significant losses or get shaken out of what eventually become profitable positions. But collars can help you avoid those fates.
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 they are used mainly during down markets.
A Stock Option Collar in Action
This is how stock option collars work: The investor has a long position in a stock
(wants their shares to rise), then 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.
The following example should help clarify. Say we own 100 shares of Company XYZ, which trades at $45. To implement a proper collar, we would buy one put with a strike price of $40 and sell a call with a strike price of $50 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 $5 per share on the trade no matter how high XYZ rises or how low it falls. If XYZ rises above $50, the person who bought our call will exercise their option and we sell the shares at $50, meaning we make a $5 profit per share -- plus we get to keep the premium that the investor paid for the option.
If XYZ shares fall below $40, we have the put to protect our position and are able to sell the shares at $40 no matter how low they fall -- meaning we only lose $5 per share. And if XYZ is trading between $40 and $50 upon expiration of our options, they expire worthless. This means we would still have our shares and the premium we received for the call option.
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 in order to offset
the put's cost. That way, you are provided the downside
protection of a put without as high a cost.
Profit Potential of Stock Option Collars
Stock option collars are a neutral strategy. Their primary objectives are capital
preservation and limiting risk, not generating large profits. That said, we can help ourselves by earning a small profit on the difference between the gain
of selling a call minus the cost of buying the put. For example, if the calls we wrote 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). There we have a small $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 makes it more likely the shares would be called away
and 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 the way some other options strategies do. That is why the prudent investor exploits the benefits of collars in a bear market
. You can think of the stock option collar as a "preserve and protect" tool when opportunities for capital appreciation
are either too risky or hard to find.