Collar, also known as hedge wrapper, is an options trading strategy many traders implement when they anticipate bullish market conditions.
Traders use this strategy to protect themselves from downward movement in the market, which as a result, experience heavy losses.
This article discusses the options strategies collar, the maximum profit and loss the traders can experience, and also when it is the ideal time to implement it.
About the Collar Options Strategy
The collar is a well-known advanced options trading strategy that involves holding shares of the underlying stock, buying protective puts, and writing call options for the same underlying at the same time.
This strategy limits the upside and the downside. In other words, the strategy gives the trader a limited return and protects him from large losses.
As a trader, you perform the options strategies collar by holding an underlying stock, purchasing an out-of-the-money put option, and selling an out-of-the-money call option.
How does the collar options strategy work?
The collar options strategy involves holding a long position on the underlying stock and the out-of-the-money put option, as well as a short position on the out-of-the-money call option.
Since you have a long position on the underlying stock, you will earn a profit once its price increases. That said, your profit is limited once the market starts moving upward. When the price starts to decrease, you will experience a loss.
How to structure collar options strategy
If you want to lock a specific price, you need to buy one ATM at the same strike price and sell one ATM call with the same strike price. However, many investors are looking to lock in a price range.
To do that, you need to buy one OTM put with a lower strike price and sell one OTM call option with a higher strike price. The two different strike prices are the price range that you can walk in an underlying stock position.
Then, if the stock price goes up, the loss from selling a call option will be offset by the gain from your underlying stock. If the stock price goes down, you will gain profit from your put option, and the losses from the underlying stock will cancel each other out, and your profit and loss will be limited to both strike prices.
Maximum profit from options collar strategy
The maximum profit when it comes to the options strategies collar occurs when the underlying price is higher than the strike’s price of the call option. Maximum profit depends on whether the trader has established the trade on the net debit or the net credit.
Maximum profit for collar = Call strike price – stock price – net debit
Maximum profit = Call strike price – stock price + net credit
Maximum loss from options collar strategy
On the other hand, a loss happens when the price of the underlying stock is less than its purchased price adjusted for the premiums received.
Maximum loss = Stock price – put strike price – net debit that is paid
Maximum loss = Stock price – put strike price + net credit received
Breakaway points
The collar option has a one breakaway point but is calculated depending on whether the trade is established at a net credit or debit.
Break-even point = current stock price + net debit
Break-even point = current stock price – net credit
Volatility and time decay
The volatility on the market doesn’t have a lot of influence on the options strategies collar as the trader established short and long option positions.
Hence, the collar is a useful strategy in a volatile market, protecting the trader for a little cost and allowing them to limit their potential loss when the stock trades down.
The time decay regarding this options strategy is beneficial for the trader when the underlying stock price goes up to the short call strike.
On the other hand, time decay hinders the trade when the stock price is near the long put strike, and its neutral stock price is about equal between the two strikes.
Collar Options Strategy Example
Let’s say an XYZ stock is trading at $100. Then, you own 200 shares of stock and plan on holding this position in your portfolio as you believe the stock has growth potential. However, you are worried that the stock might be negatively affected.
Hence, you are looking for a strategy to hedge your stock position instead of selling it. The ideal price range of the stock is from $95-$105, regardless of the price movements. To execute the trade, you buy put options at a $95 strike for $4.7.
Then, you sell call options at a $105 strike price with the same premium price. The premium you pay for the put option will be offset by the income you will earn from selling call options.
When to Use Collar Option Strategy
This is an options strategy to use when you expect the stock to trade down or sideways. You can also implement this strategy when you expect the stock price to increase over time but don’t want to sell your shares. This is the strategy to implement when you want to trade options but don’t want to take high risks.
When the price of the underlying asset decreases, you will profit by using a protective put option. Selling the covered call option will allow you to pay for the put option and still have the opportunity to profit from an increase in the underlying asset up to the call's strike price.
The term "zero-cost collar" refers to a situation in which selling the call option completely offsets the cost of the put option.
A collar may be considered if a stock has significant long-term potential but short-term downside risk. This strategy is not favorable when the underlying asset moves higher.
Who is the collar options strategy suitable for?
This options strategy is suitable for investors with extensive trading knowledge, experience, and trading skills. As an investor, you need to select strike prices that align with your trading objectives.
Become a Successful Trader
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Advantages and Disadvantages of the Collar Options Strategy
Advantages
- Limits losses from falling stock value
- Less expensive than only buying puts
- The trader owns the underlying and can get ownership benefits
Disadvantages
- The strategy can be complex for beginner traders
- It limits gains from the rising stock values
Key Takeaways
- The collar is an options trading strategy that limits profits and losses.
- It involves buying an out-of-the-money put option and selling an out-of-the-money call option while holding an underlying.
- Investors generally use it to hedge the long position in the underlying stock from downside risk.
Reverse Collar Strategy
As the name suggests, a reverse collar strategy involves making the opposite movements than the traditional strategy. This strategy limits an underlying short position to a specific trading range.
In this case, the investor with a short position sells covered puts and sells and buys protective calls instead of writing covered calls and buying puts.
Conclusion
The options strategies collar is a strategy that provides limited profit with less risk. This strategy works best for stock positions with a large position size in a long-term portfolio when there is a substantial amount of unrealized profit.
This strategy limits gains and losses, and traders often use it to limit the overall risk in their portfolios. The main objective of this strategy is to protect profits rather than increasing returns.