The Collar Strategy Explained

Collar Options Trading Strategy Explained

Published on Wednesday, April 18, 2020 | Modified on Wednesday, June 5, 2020

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Collar Options Strategy

A Collar is similar to Covered Call but involves another position of buying a Put Option to cover the fall in the price of the underlying. It involves buying an ATM Put Option & selling an OTM Call Option of the underlying asset. It is a low risk strategy since the Put Option minimizes the downside risk. However, the rewards are also limited and is perfect for conservatively Bullish market view.

Suppose you are holding shares of SBI currently trading at в‚№250. You can deploy a collar strategy by selling a Call Option of strike price в‚№300 while at the same time purchasing a в‚№200 strike price Put option. If the price rises to в‚№300, your benefit from increase in value of your holdings and you will lose net premiums. If the price falls to в‚№200, you will lose value of your holdings but will benefit from exercising the Put option.

When to use Collar strategy?

The Collar strategy is perfect if you’re Bullish for the underlying you’re holding but are concerned with risk and want to protect your losses.

Example

Suppose you are holding ULTRATECH cements, currently trading at в‚№4780, or plan to buy it expecting a rise in its price in the near future. You also want to protect yourself from losses in case the stock moves downwards. In such a scenario, you can use the Collar strategy by selling a Call at в‚№5000 for a premium of в‚№40 and simultaneously buying a Put at в‚№4700 for a premium of в‚№30.

Scenario 1: Price of ULTRATECH rises to в‚№5100

You can sell the stock or your holding will gain higher on paper value at в‚№5000. If sold, your profit will be в‚№220 (в‚№5000 – в‚№4780). When the net premium received of в‚№10 is factored in, your profit increases to в‚№230. The Put option will be worthless on expiry. Call option will be exercised and you have to pay в‚№100.

So net profit for you will be: в‚№220 + в‚№10- в‚№100 = в‚№130

Scenario 2: Price of ULTRATECH falls to в‚№4600

Your holdings will lose value on paper by в‚№180. You can exercise the Put option and earn в‚№100. The Call Option will be worthless on expiry. When the net premium received of в‚№10 is factored in, your loss will be: – в‚№180 + в‚№100 + в‚№12 = в‚№68

Market View – Bullish

When you are of the view that the price of the underlying will move up but also want to protect the downside.

Actions

• Buy Underlying
• Buy 1 ATM Put Option
• Sell 1 OTM Call Option

Breakeven Point

Price of Features – Call Premium + Put Premium

What is a Collar Strategy?

A collar is similar to Covered Call but involves another leg—buying a Put to insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a Collar is buying a stock, insuring against the downside by buying a Put and then financing (partly) the Put by selling a Call.

The put generally is ATM and the call is OTM having the same expiration month and must be equal in number of shares. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservatively bullish. The following example should make Collar easier to understand.

When to use: The collar is a good strategy to use if the investor is writing covers calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security.

Breakeven: Purchase Price of Underlying—Call Premium + Put Premium

Example

1. If the price of ABC Ltd. rises to Rs. 5100 after a month, then,

• Mr. A will sell the stock at Rs. 5100 earning him a profit of Rs. 342 (Rs. 5100—Rs. 4758)
• Mr. A will get exercised on the Call sold and will have to pay Rs. 100.
• The Put will expire worthless.
• Net premium received for the Collar is Rs. 12.
• Adding (a +b+d)= Rs. 342—100—12= Rs. 254

This the maximum return on the Collar Strategy

However, unlike a Covered Call, the downside risk here is also limited:

2) If the price of ABC Ltd. falls to Rs. 4400 after a month, then,

• Mr. A loses Rs. 358 on the stock ABC Ltd.
• The Call expires worthless
• The Put can be exercised by Mr. A and he will earn Rs. 300
• Net premium received for the Collar is Rs. 12
• Adding (a+b+d)= —Rs. 358+ 300 +12= —Rs. 46

This is the maximum the investor can loose on the Collar Strategy. The Upside in this case is much more than the downside risk.

Get to know more about online trading strategies in our knowledge base section.

Collar

What is a Collar?

A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains. An investor creates a collar position by purchasing an out-of-the-money put option while simultaneously writing an out-of-the-money call option. The put protects the trader in case the price of the stock drops. Writing the call produces income (which ideally should offset 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.

What is a Protective Collar?

Understanding the Collar

An investor should consider executing a collar if they are currently long a stock that has substantial unrealized gains. Additionally, the investor might also consider it if they are bullish on the stock over the long term, but are unsure of shorter term prospects. To protect gains against a downside move in the stock, they can implement the collar option strategy. An investor’s best case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.

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.

The purchase of an out-of-the-money put option is what protects the trader from a potentially large downward move in the stock price while the writing (selling) of an out-of-the-money call option generates premiums that, ideally, should offset the premiums paid to buy the put.

The call and put should be the same expiry month and the same number of contracts. 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 trade should be set up for little or zero out-of-pocket cost if the investor selects the respective strike prices that are equidistant from the current price of the owned stock.

Since they are willing to risk sacrificing gains on the stock above the covered call’s strike price, this is not a strategy for an investor who is extremely bullish on the stock.

Key Takeaways

• A collar, commonly known as a hedge wrapper, is an options strategy implemented to protect against large losses, but it also limits large gains.
• The protective collar strategy involves two strategies known as a protective put and covered call.
• An investor’s best case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.

Collar Break Even Point (BEP) and Profit Loss (P/L)

An investor’s break even point on this strategy is the net of the premiums paid and received for the put and call subtracted from or added to the purchase price of the underlying stock depending on whether there is a credit or debit. Net credit is when the premiums received are greater than the premiums paid and net debit is when the premiums paid are greater than the premiums received.

• BEP = Underlying stock purchase price + Net debit
• BEP = Underlying stock purchase price – Net credit

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.

• Maximum Profit = (Call option strike price – Net of Put / Call premiums) – Stock purchase price
• Maximum Loss = Stock purchase price – (Put option strike price – Net of Put / Call premiums)

Collar Example

Assume an investor is long 1,000 shares of stock ABC at a price of $80 per share, and the stock is currently trading at $87 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 (one option contract is 100 shares) with a strike price of $77 and writes 10 call options with a strike price of $97.

Cost to implement collar (Buy Put @ $77 & write Call @ $87) is a net debit of $1.50 / share.

Break even point = $80 + $1.50 = $81.50 / share.

The maximum profit is $15,500, or 10 contracts x 100 shares x (($97 – $1.50) – $80). This scenario occurs if the stock prices goes to $97 or above.

Conversely, the maximum loss is $4,500, or 10 x 100 x ($80 – ($77 – $1.50)). This scenario occurs if the stock price drops to $77 or below.