Understanding the option collar strategy

Why use an option collar?

The primary reason traders and businesses use collars is to reduce the risk of price volatility. Examples include:

• Producers and farmers: to ensure a minimum income while accepting a ceiling on profits.
• Importers and exporters: to protect against unfavourable currency exchange rate changes.
• Cost-effectiveness: since selling the call option generates income to cover the cost of the put option, collars are an economical hedging strategy. In some cases, they can be created at no net cost (a zero-cost collar).
• Certainty for financial planning: by defining a price range for the underlying asset, traders can plan with more confidence. For example, an energy company might use a collar to stabilise revenue during periods of market volatility.

Choosing strike prices and expiration dates

The effectiveness of a collar depends on selecting the right strike prices and expiration dates for the options.

Strike Price Selection:

• Put strike should be set below the current market price to determine the level of downside protection. A lower strike price makes the put cheaper but exposes you to more risk.
• Call strike should be set above the current market price to cap your potential gains. A higher strike price gives more upside but generates less income to offset the cost of the put.
• For zero-cost collars, the call strike price is usually selected so that the premium received equals the cost of the put.

Expiration Date Selection:

• The expiration date should match your hedging timeline. For example, a farmer anticipating a harvest in three months might choose options expiring in three months.
• Consider liquidity and transaction costs. Options with shorter expiration dates often have higher trading volumes and narrower price spreads, making them cheaper to trade.

Alternative hedging strategies

While collars are versatile, other strategies can also manage risk:

• Protective puts. Buying a put option provides full downside protection without limiting upside potential. However, this comes at a higher cost because there’s no offsetting income from selling a call.
• Covered calls. Selling a call option against an existing position generates income but doesn’t protect against price declines. This strategy works well if you’re confident the market will remain relatively stable or move slightly higher.
• Futures contracts. Directly buying or selling futures provides price protection but requires maintaining margin and doesn’t offer the predefined price range that collars provide.
• Synthetic strategies. Combining options and futures can replicate the effects of other hedging strategies. For example, a synthetic long position might be constructed using options to mimic the payoff of holding the underlying asset.

Pros and cons of an option collar

While an option collar is a highly effective risk management tool, it is important to understand both its advantages and limitations before implementation.

Pros:

• Cost efficiency. The income from the sold call option offsets the cost of the purchased put option. In some cases, this creates a low-cost or zero-cost collar, where the hedging cost is entirely neutralised. This makes the strategy an economical choice for managing risk.
• Defined risk and reward. A collar establishes a clear price range for the underlying asset. This range provides a degree of certainty by capping both potential losses and gains. Such clarity is especially valuable in markets prone to volatility.
• Customisability. Collars can be tailored to suit the specific needs of traders or businesses. The strike prices and expiration dates of the options can be adjusted to match individual risk tolerance, financial goals, and market outlook.
• Peace of mind. For producers, exporters, and other market participants, collars can stabilise cash flows and protect against adverse price movements. This stability allows for better financial planning and decision-making.

Cons:

• Capped upside potential. Selling the call option limits the profit you can make if the market price rises significantly. For traders expecting substantial price increases, this could lead to missed opportunities.
• Complexity. Constructing and managing a collar requires an understanding of options and their pricing mechanisms. Novice traders might find this strategy challenging without proper guidance or expertise.
• Liquidity risks. Some options markets, especially for less popular futures contracts, may have low liquidity. This can lead to wider bid-ask spreads, higher transaction costs, and difficulties in entering or exiting positions.
• Opportunity cost. If the market experiences rapid price increases, the capped gains from the collar might seem like a disadvantage compared to other strategies with unrestricted upside potential.

Understanding the role of option greeks

The Greeks are key metrics used to evaluate how an options strategy behaves under different market conditions. For collars, they help explain the strategy’s sensitivity to price movements, time decay, and volatility.

Delta (Directional risk)

• The put option has a negative delta, meaning it benefits when prices fall.
• The call option has a positive delta, meaning it benefits when prices rise.
• Together, the net delta of a collar tends to offset price movements, depending on the strikes and the underlying position. This reduces overall directional risk.

Gamma (Rate of change of delta)

• Collars have low gamma, meaning that the delta of the combined position changes gradually as the market price moves. This makes collars less reactive to price fluctuations compared to other options strategies.

Theta (Time decay)

• The sold call option generates positive theta, meaning its value decreases as expiration approaches (benefiting the seller).
• The purchased put option has negative theta, meaning its value also decreases over time (costing the buyer).
• The two effects partially offset each other, reducing the impact of time decay on the collar as a whole.

Vega (Volatility sensitivity)

• Higher market volatility generally increases the value of options.
• The put option benefits from increased volatility, while the call option loses value.
• Since the collar involves both a call and a put, the strategy’s overall sensitivity to volatility changes is reduced.

Rho (Interest rate sensitivity)

• Collars are generally less sensitive to changes in interest rates, especially for short-term positions. However, small shifts in option pricing can occur due to rate changes.

When should you use an option collar?

Option collars are best suited for traders and businesses seeking a balance between risk protection and cost efficiency. Here are some common scenarios:

• Hedging against price declines. Producers, such as farmers or energy companies, often use collars to safeguard against falling prices while accepting a limit on potential profits. This ensures that they can secure a minimum revenue.
• Locking in a price range. Importers and exporters frequently use collars to manage currency exchange risks. By defining a price range, they can stabilise costs or revenues despite fluctuations in exchange rates.
• Reducing volatility exposure. Traders operating in volatile markets may adopt collars to protect their positions from sudden price swings without incurring high hedging costs.
• Financial planning and budgeting. Businesses that rely on stable cash flows can use collars to reduce uncertainty and make more accurate financial forecasts.

Alternatives to an option collar

While collars are flexible and effective, they are not the only tool available for managing risk. Traders might consider these alternatives:

• Protective puts. Buying a put option provides full downside protection without limiting upside potential. However, this comes at a higher cost because there’s no offsetting income from selling a call.
• Covered calls. Selling a call option against an existing position generates income but doesn’t protect against price declines. This strategy works well if you’re confident the market will remain relatively stable or move slightly higher.
• Futures contracts. Directly buying or selling futures provides price protection but requires maintaining margin and doesn’t offer the predefined price range that collars provide.
• Synthetic strategies. Combining options and futures can replicate the effects of other hedging strategies. For example, a synthetic long position might be constructed using options to mimic the payoff of holding the underlying asset.

Conclusion

An option collar is a highly practical strategy for futures market participants looking to balance risk and cost. By combining a purchased put and a sold call, it creates a defined price range that protects against unfavourable market movements while limiting potential gains.

The strategy’s flexibility allows traders to tailor it to their needs, making it a preferred choice for many. However, careful consideration of strike prices, expiration dates, and potential alternatives is essential to ensure it aligns with your objectives. While it has limitations, such as capped upside and market complexity, the collar remains a valuable tool for hedging in volatile environments.