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Collar Option Strategy
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.