Sales Trader
Summary: Collar is an option strategy used by investors and traders to reduce portfolio volatility through a combination selling and buying of options. This is done by limiting both upside and downside of an underlying asset over the short term. A collar position is created by combining the protective put and covered call option strategy at the same time.
What is the Collar Option Strategy?
Collar Position = Underlying Stock + Long Out of The Money Put Option + Short Out of The Money Call Option
The strategy is typically used by investors who are concerned about the downside risks of their holdings in the short term. The investors sell an out of the money call option while simultaneously buying an out of the money put option on the same underlying stock thereby capping the upside in order to fund the premium to buy downside protection.
Selling an out of the money call option involves choosing a call option with a strike higher than the current trading price of the stock ( Stock trading at $170, call strike at $180). Buying an out of the money put option involves choosing a put option with a strike below the current trading price of the stock (stock trading at $170, put strike at $160).
Why use the Collar Option Strategy?
Collar strategy is an alternative to traders who are looking to hedge the downside risks of the stocks in the short term but have no intention to sell the stock for the fear of short-term risks. Therefore they are comfortable to commit to capping their profits by selling the call option and using that premium to buy protection against downside risks.
Legend
Kp = Strike price for OTM put option
Kc = Strike price for OTM call option
This is the pay-off diagram for using a collar option strategy. The trader/investor would have limited losses when the price of the stock falls below the put option’s strike price of Kp. However, if the stock rises above the call option’s strike price of Kc, the trader/investor would have limited upside.
Example
A client owns 100 shares in Apple trading at the price of $170. He sells 1 call option at strike $180 with a 1 month expiry. At the same time, he also buys a put option at strike of $160. The premium received from selling the call option is $3 while the cost of buying the put option is $1. In this example, Apple call options are more expensive than put options (positive skew), but the skew could also go the other way or stay flat depending on the prevailing interest rates and market sentiment.
You would receive a net premium of $2 credit per share with this structure. If you wish to make this trade a zero-cost strategy, you can afford to buy a put option with a higher strike that cost up to $3. This would offer greater downside protection.
Max gain per share is when Apple rises to $180
$3 (premium received from selling call option) - $1 (premium paid for buying put option) + $10 ( gain from owning Apple shares) = $12
Breakeven point
$170 + $3 (premium received from selling call option) - $1 (premium paid for buying put option) = $168
Max loss per share if Apple falls below $160
$3 (premium received from selling call option) - $1 (premium paid for buying put option) - $10 ( loss from owning Apple shares) = -$8
Scenario 1 – Apple trades to $175
P&L = $3 (premium received from selling call option) - $1 (premium paid for buying put option) + $5 ( gain from owning Apple shares) = $7
Scenario 2 – Apple trades to $165
P&L = $3 (premium received from selling call option) - $1 (premium paid for buying put option) - $5 ( Loss from owning Apple shares) = -$3
Uses of the Collar Option Strategy
The collar option strategy is yet another tactical option in a trader/investor’s toolkit to help hedge their positions in the portfolio over the short to medium term. If an investor holds a large position in a particular stock, they can construct a collar position to protect against short-term downside risks without letting go of the stock. The cost of purchasing the protective put option to hedge against the fall in price of the underlying asset can be offset from the sale of the covered call. If the cost of the put option is covered entirely by the sale of the call option, this can be called a zero-cost collar. If the cost of the put option is lower than the premium receive by the sale of the call option, then this works as a part hedge and part yield enhancement strategy.
As the collar options are more frequently used as a tactical strategy, a trader/investor has plenty of flexibility when employing this strategy and can choose to use this on some or all of their stock holdings in different market conditions.
The end of the road
Emboldened by surging crude oil prices, Saudi Arabia makes waves on the international stage, as Crown Prince Mohammed bin Salman manages to create a World Champions League, after buying the UEFA Champion League franchise.
As the world embraces GLP-1 obesity wonder drugs, the people next in line to get a prescription stop caring about dieting and exercising, figuring that the drug will later solve all of their weight-related health problems.
With the US budget deficit spiraling above 10% of the GDP, the government is desperate to foster demand for US Treasuries. Under intense pressure from the White House, Congress makes income from government bonds tax-free.
After a criminal group deploys the most deceptive AI deepfake ever seen, generative AI becomes a national security threat. With public distrust soaring, governments crack down with harsh new laws, puncturing the AI hype.
To fix the divergence in the global trade and financial system, the largest deficit countries unite to negotiate new world trade terms. For surplus countries, the reset of the global economic model is a painful adjustment.
As discontent with Biden and Trump rises to fever pitch, Robert F. Kennedy Jr sees his support rising inexorably in the polls. On November 5, Kennedy wins the US presidential election, ushering in a new era in US politics.
Stepping up Japan's economic transformation in 2024, PM Kishida brings in a host of populist policies to boost domestic demand. As the GDP growth rate hits 7%, the BoJ is forced to abandons its yield curve control policy.
As people wake up to how little tax Europe’s billionaires are actually paying, the EU Commission implements a wealth tax of 2%. The tax sends shockwaves through Europe's luxury industry, with luxury giant LVMH plunging 40%.
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)
