Collar Option Strategy

The options collar strategy is designed to limit the downside risk of a held underlying security.

It can be performed by holding a long position in a security, while simultaneously going long a Put and shorting a Call.

STRATEGY

If an investor is concerned about a large drop in the price of a stock position, he or she can pursue a collar to place a limit to its possible losses. This strategy is used when, for example, the underlying security is experiencing heavy volatility with a bearish expectation regarding its price movement. While putting a floor on losses, a collar also caps up-side profit potential.

Constructing a collar strategy can be done by holding the underlying, purchasing an out-of-the-money put, and selling an out-of-the-money call. Both options contracts must expire on the same date.

PROFIT/LOSS DEPICTION

The graph below shows the loss and profit from a collar. It plots the profit and loss as a function of price in the underlying security.

PROFIT/LOSS EXAMPLE

You own 50 shares of Stock XYZ, which is currently trading at $60. You are bearish regarding its stock performance, and wish to limit your losses with the use of a collar strategy. You perform the following transactions:

ð Long a put with a strike price of $50, cost of $150, and a 1 month expiration (out of money)

ð Short a call with a strike price of $70, a premium of $250, and a 1 month expiration (out of money)

Scenario 1: XYZ is trading at $60 at expiration

Outcomes:

ð You gain $0 from your stock position

ð Your long put and short call expire worthless

ð Your profit is the premium gain minus the option cost

COLLAR PROFIT:

Collar Profit = Call Premium received – Put Option Cost

= $250 – $150 = $100

Scenario 2: XYZ is trading at $75 at expiration

Outcomes:

ð You gain $250 from your stock position

ð You lose $250 on the short call. For a short call position, a stock price higher than the strike price will yield a loss.

ð Your long put option is worthless. For a long put position, a stock price higher than strike price makes it worthless.

COLLAR PROFIT:

Gain on Stock Position = (Ending Stock Price – Beginning Stock Price) X Number of shares held

= ($75 – $60) X 50 shares = $750

Value of Short Call = – (Stock Price – Ending Strike Price) X Number of shares held

= – ($75-$70) X 50 shares = $-250

Collar Profit = Call Premium received – Put Option Cost + Gain on Stock XYZ + Value of Call Option

= $250 – $150 + $750 – $250 = $600

This also happens to be the maximum profit possible from this collar strategy.

Scenario 3: XYZ is trading at 45 at expiration

Outcomes:

ð You lose $750 from your stock position

ð You gain $250 on the long put. For a long put position, a stock price lower than the strike price will yield a gain

ð Your short call option is worthless. For a call position, a stock price lower than strike price makes it worthless.

COLLAR LOSS:

Gain on Stock Position = ( Ending Stock Price – Beginning Stock Price) X Number of shares held

= ($45 – $60) X 50 shares = – $750

Value of LongPut = (Strike Price – Ending Stock Price) X Number of shares held

= ($50 – $45) X 50 shares = $250

Collar Profit = Call Premium received – Put Option Cost – Loss on Stock XYZ + Value of Put Option

Collar Profit = $250 – $150 – $750 + $250 = – $400

This also happens to be the maximum loss possible from this collar strategy.

CONCLUSION

A collar can be an effective options strategy that is used to place a limit on losses of a volatile stock that is expected to drop in value. By holding the stock, purchasing an out-of-the-money put, and writing an out-of-the-money call, a trader can basically place a lower limit on his losses. Doing so however, also caps the potential profit possible. It is therefore typically used with a bearish sentiment regarding a stock.