Back
Details Cookies
United Kingdom
Important margin product information

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs, FX or any of our other products work and whether you can afford to take the high risk of losing your money.

Cookie policy

This website uses cookies to offer you a better browsing experience by enabling, optimising and analysing site operations, as well as to provide personalised ad content and allow you to connect to social media. By choosing “Accept all” you consent to the use of cookies and the related processing of personal data. Select “Manage consent” to manage your consent preferences. You can change your preferences or retract your consent at any time via the cookie policy page. Please view our cookie policy here and our privacy policy here

Protecting a long stock market position from turbulence Protecting a long stock market position from turbulence Protecting a long stock market position from turbulence

Protecting a long stock market position from turbulence

Summary:  The stock markets experienced a positive start this year; since mid-February, however, prices have faltered. This article introduces you to an options structure called a collar, which protects you from large price declines, but allows you to maintain a position and even profit when prices rise.


An option collar: reducing downside risk while maintaining some upside potential

Stock markets got off to a strong start to the year. By mid-February, global indices were up about 10%. Sticky inflation, further rising interest rates, tightening monetary policy and central banks deleveraging balance sheets caused the markets to falter from then on. With the bankruptcy of Sillicon Valley Bank and the mounting tension around Credit Suisse, turbulence in the stock market has intensified in recent weeks. It makes investors - who regularly hover between hope and fear - look for ways to protect their portfolios. One way to reduce risk while maintaining upside potential - markets sometimes recover faster than expected - is to use an options collar.

What is a collar?

A collar has three building blocks:

  • a long stock, or other, underlying position
  • a long out-of-the-money put option
  • a written (sold) out-of-the-money call option with the same expiration date as the long put

In short, the long put is an insurance policy on the underlying position, and the short call is a way to somewhat reduce the insurance premium paid.

Typically, the strategy - which is also popular with professional investors - is applied to individual stocks. However, it can also be done relatively easily at a portfolio level if the portfolio is in close correlation with the broader market. The examples below will assume the “portfolio” equates to a position in the S&P 500.

For convenience, in this article, we do not take into account possible dividends or market liquidity (spreads).

Trading an options collar: a practical example

For our example, let’s assume a position/portfolio value of about US$400,000 (current S&P 500 value of 4,000 times 100, the contract size for options on the index) and you want to go on summer vacation with peace of mind, concerned about recent market turmoil. By the way, one can generally divide all the calculations by 10 for a $40,000 position/portfolio using options on the SPY ETF, which tracks the S&P 500 cash index (price is the index divided by ten.)

Back to the example. The idea of the collar is that you buy a Sep ’23 put on SPX with a strike price of 3,850 and sell a call for SPX Sep '23, strike price: 4,400. At the time of writing this article, you will pay just under US$145 for the put. As with options on individual shares, you have to take into account the contract size of 100, so you will pay about US$14,500 in premium (cost of the option). For the call, you will receive almost US$60, or US$6,000 in premium. 

On balance, the premium is $8,500, and the structure gives you protection for any downside beyond 3,850 points in the SPX index until the third Friday in September. You can visualise this in your account; see Figure 1 below. (by the way, being long the underlying while simultaneously owning the collar, as discussed below, prevents any loss on the position beyond the call strike price.)

Figure 1: Collar p3850/c4400 SPX September 2023

As an investor, it is important to understand how different scenarios impact your position. First, I’ll discuss the situation of a large decline, then that of a recovery (rise). I’ll conclude with a sideways movement of the market.

Scenario 1: The S&P 500 falls to 3,850

With a collar position, the investor will still lose on a market drop, but only up until the maximum risk point, which is reached at the strike price of the long put “leg” of the collar, which, in our example, is at 3,850 at September expiry, or $23,500.

If 3,850 is the index level at expiry, the profit/loss of the structure is:

Loss on SPX position -$15,000 ($400,000 less $385,000)

Cost of 3,850 put premium: -$14,500 ($145 x 100 x SPX)

Premium of 4,400 short call: +$6,000

Total P/L: -$29,500 + $6,000 = -$23,500

In percentage terms, the maximum total loss is -5.75% (-23,500/408,500). We use 408,500 because of the extra cost of the options collar. Note that this loss is the same at September expiry whether the S&P 500 is at 3,850 or 3,000 or even at 0 for that matter. That’s because the value of the put on expiry rises 1:1 as a function of the fall in the underlying SPX position as the put moves “into the money” (below the strike price).

Had you never bought the collar, your loss at 3,850 would only be $15,000 dollars, it should be noted. The same maximum loss (-$23,500) in the underlying in USD terms would be at 3,765.

What course of action is available on a large market drop before expiry?

One advantage of owning long options is the flexibility for follow-up action before expiry. Let’s say that the market falls badly before September expiry and is trading around 3,600, a large 10% market drop. The call premium is now way out of the money (800 points, or 4,400-3,600) and is only worth perhaps $7 x 100, or $700, while the 3,850 put option is now deep in the money (250 points, or 3,850-3,600) and still has some time value remaining – let’s say it is worth $302.00 x 100, or $30,200).

At this point, the collared position looks like this:

  • Market value of stock portfolio -$40,000 ($400,000-$360,000)
  • Market value of long put option +$15,700 ($30,200 - $14,500 cost)
  • Market value of short call option +$5,300 ($6,000 less cost to buy back at $700)

Overall, with this sharp drop, the approximate result is a loss of -$19,000. That's 4.65% of the initial investment (19,000/408,500), far less than the 10% loss for the S&P 500 (drop from 4,000 to 3,600). Just keep in mind that the example above is an example only and will depend on time remaining to expiry and implied volatility levels used to calculate options prices.

What now? At this point, you can continue to hold the position, which will result in the $23,500 loss discussed above if the SPX is trading at 3,850 or lower at expiry. But you can also take profit on the collar (sell the put and buy back the call) and keep the underlying position if you expect the market to recover. If the market subsequently recovers to 4,000, you will have an overall gain of $10,500 ($400,000 value of SPX position + $19,000 profit on the collar less $408,500 from starting point). If, on the other hand, the market falls further to 3,400, you will have a loss of -$49,500 ($340,000 new value of SPX position less $408,500 original risk plus +$19,000 profit on collar).

Scenario 2: What if the stock market recovers?

Suppose the stock market doesn’t drop any further, but instead resumes the advance of the beginning of the year? How would the value of the portfolio develop? Basically, the short call strike price is the “cap” or maximum profit level for a collared position. If the index is at 4,400 on expiration, the underlying equity portfolio has risen from US$400,000 (index 4,000) to US$440,000 (index 4,400). A gross profit of US$40,000. Taking into account the collar cost of US$8,500, a net profit of US$31,500 remains in this situation. That's 7.71% (31,500/408,500). Not bad for a strategy set up primarily to reduce risk. To be clear: even if the S&P 500 is at 4,600 or 5,000 points, the maximum result remains US$31,500 (7.71%). In this situation, do take into account cash settlement of the short call.

Good to know: if the rise of the S&P 500 occurs gradually over time, the maximum result only comes into view towards the maturity date of the options.

Scenario 3: What if the market moves sideways?

Suppose the S&P 500 floats around aimlessly near 4,000, what does this mean for the overall portfolio? In this scenario, the $8,500 collar net premium cost will slowly decline in value as it loses time value and expires worthless at expiration. This $8,500 is therefore the maximum loss in this scenario, or 2.08% (8,500/408,500).

Time decay is a gradual process. For this example, let’s simulate what our collar with the same strike prices looks like three months down the road by looking at options for the same collar that expires in June rather than September.

The value of the put would go from $145 to approximately $95. So the put loses $50 (US$5000) in three months. And the 4,400 call price drops from almost $60 to about $20. Since you initially sold the call, this means a profit of $40 ($4,000). In total, the collar will cost you an estimated $1,000 in three months. Of course, the actual result may differ somewhat.

What else? Should the index move sideways for three months, but you still don’t trust the markets, you can choose to close the 'September collar' and take your loss of about $1,000. You can then set up a new collar. For example, again a long put 3,850 and a short call 4,400 but extend the maturity until December 2023.

The collar in a nutshell

A collar allows you to build in a certain amount of protection. It is not a construction for pursuing high returns. It is a safety belt for the underlying portfolio while maintaining some upside potential if the underlying instrument rises.

Of course, there are any number of variants of this approach. Depending on your risk profile, you can vary the strategy, for example, considering puts that are farther out of the money, calls that are closer to the money (which makes the collar cheaper, but limits profit potential), selling the legs of the collar at different times depending on what the underlying is doing, or even using call and put legs with different maturities. Options offer a huge range of, well, interesting options for the investor.

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)

Saxo Markets
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Support Centre
For existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo Markets is a registered Trading Name of Saxo Capital Markets UK Ltd (‘SCML’). SCML is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo Markets assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.