A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.
|Collar Strategy Construction|
|Long 100 Shares|
Sell 1 OTM Call
Buy 1 OTM Put
Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put.
The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.
The formula for calculating maximum profit is given below:
The formula for calculating maximum loss is given below:
The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.
Suppose an options trader is holding 100 shares of the stock XYZ currently trading at $48 in June. He decides to establish a collar by writing a JUL 50 covered call for $2 while simultaneously purchases a JUL 45 put for $1.
Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but receives $200 for selling the call option, his total investment is $4700.
On expiration date, the stock had rallied by 5 points to $53. Since the striking price of $50 for the call option is lower than the trading price of the stock, the call is assigned and the trader sells the shares for $5000, resulting in a $300 profit ($5000 minus $4700 original investment).
However, what happens should the stock price had gone down 5 points to $43 instead? Let's take a look.
At $43, the call writer would have had incurred a paper loss of $500 for holding the 100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his shares for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500 minus $4700 original investment).
Had the stock price remain stable at $48 at expiration, he will still net a paper gain of $100 since he only paid a total of $4700 to acquire $4800 worth of stock.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The beauty of using a collar strategy is that you know, right from the start, the potential losses and gains on a trade. While your returns are likely to be somewhat muted in an explosive bull market due to selling the call, on the flip side, should the stock heads south, you'll have the comfort of knowing you're protected.
The following strategies are similar to the collar strategy in that they are also bullish strategies that have limited profit potential and limited risk.
If capital protection rather than premium collection is the main focus, a bullish investor can establish an alternative collar strategy known as the costless collar.
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