What Is Collar?
A collar is an options trading strategy employed by investors to limit both potential gains and losses on an existing position in an underlying asset, typically a stock. This strategy falls under the broader category of derivatives and is a form of hedging against significant price fluctuations. A collar is constructed by holding shares of a stock, buying an out-of-the-money put option, and simultaneously selling an out-of-the-money call option with the same expiration date. The put option provides downside protection, while the sold call option generates premiums that can offset the cost of the put, but also caps the potential upside profit.
History and Origin
The concept of options, which are fundamental to the collar strategy, can be traced back centuries, with ancient Greek philosophers speculating on olive harvests. However, the formal, standardized trading of options as we know them today is a more recent development. The modern era of listed options began with the opening of the Chicago Board Options Exchange (Cboe) in 1973. Cboe revolutionized financial markets by introducing standardized contracts, increasing transparency, and providing centralized liquidity4. This standardization paved the way for more complex options strategies like the collar, enabling investors to manage portfolio volatility with greater precision.
Key Takeaways
- A collar strategy combines holding a stock, buying a put option, and selling a call option to define a range of potential outcomes.
- It is primarily used for risk management, protecting against substantial downside losses in an owned asset.
- The income generated from selling the call option helps offset the cost of buying the protective put option.
- While limiting downside risk, the collar also caps potential upside profits, as the stock price rises above the call option's strike price.
- Collars are often considered by investors who are moderately bullish on a stock but seek protection from short-term adverse price movements.
Formula and Calculation
The profit or loss for a collar strategy can be calculated based on the stock's price at expiration relative to the options' strike prices and the net premium paid or received.
The maximum profit for a collar is achieved if the underlying stock's price closes at or above the call option's strike price:
[
\text{Max Profit} = (\text{Call Strike Price} - \text{Stock Purchase Price}) + \text{Net Premium Received (or - Net Premium Paid)}
]
The maximum loss for a collar is limited to the difference between the stock's purchase price and the put option's strike price, minus any net premium received:
[
\text{Max Loss} = (\text{Stock Purchase Price} - \text{Put Strike Price}) - \text{Net Premium Received (or + Net Premium Paid)}
]
The net premium is calculated as:
[
\text{Net Premium} = \text{Call Premium Received} - \text{Put Premium Paid}
]
If the call premium received is greater than the put premium paid, the investor receives a net credit. If the put premium paid is greater, the investor pays a net debit. The calculation of these values depends on the strike price and the time value of the options.
Interpreting the Collar
A collar strategy is interpreted as a method to "collar" or bracket the potential price movement of an owned stock within a defined range. By establishing a collar, an investor signals a desire to protect accumulated gains or limit potential losses in a stock, even at the expense of giving up some significant upside appreciation. The chosen strike price of the put option sets the floor for potential losses, while the strike price of the call option establishes the ceiling for potential gains. This defined risk-reward profile is particularly appealing in periods of high market volatility or when an investor wants to secure a portion of their equity while retaining some participation in price appreciation.
Hypothetical Example
Consider an investor who owns 100 shares of Company ABC stock, purchased at $100 per share. The investor is concerned about short-term market turbulence but wants to hold onto the stock long-term. To implement a collar, they might:
- Buy a protective put option: Purchase one ABC $95 put option expiring in three months for a premium of $3.00 per share ($300 total for 100 shares). This option gives them the right to sell their shares at $95.
- Sell a covered call option: Simultaneously sell one ABC $110 call option expiring in three months for a premium of $2.50 per share ($250 total for 100 shares). This obligates them to sell their shares at $110 if the call is exercised.
In this scenario, the net cost of the collar is $3.00 (put premium) - $2.50 (call premium) = $0.50 per share, or $50 total.
- If ABC stock falls to $90: The put option can be exercised, allowing the investor to sell their shares at $95. Their loss is limited to $5.00 per share ($100 - $95) plus the $0.50 net premium, totaling $5.50 per share.
- If ABC stock rises to $115: The call option will likely be exercised, obligating the investor to sell their shares at $110. Their profit is capped at $10.00 per share ($110 - $100) minus the $0.50 net premium, totaling $9.50 per share.
- If ABC stock stays between $95 and $110: Both options expire worthless, and the investor retains their shares, with their profit or loss from the stock movement reduced by the $0.50 net premium.
Practical Applications
The collar strategy finds several practical applications in portfolio management and risk management. It is frequently used by long-term investors holding a highly appreciated stock position, especially when facing potential short-term adverse events like earnings announcements or general market uncertainty. A collar allows them to protect a portion of their gains without selling the underlying shares, which could trigger a taxable event.
Furthermore, institutional investors and corporations might use collars to manage exposure to large stock holdings, such as executive stock options or company shares. For individual investors, a collar can be a thoughtful approach to balancing growth potential with downside protection, particularly for concentrated positions in their portfolio. The Securities and Exchange Commission (SEC) provides guidance for investors on options to help them understand the basics and risks involved in such strategies3. In broader economic contexts, understanding how financial markets price risks, including through options, can even inform views on market liquidity and economic conditions2.
Limitations and Criticisms
Despite its benefits as a hedging strategy, the collar has limitations. The primary criticism is that it caps potential upside profits. If the underlying stock experiences a significant rally, the investor's gains are limited to the call option strike price, meaning they miss out on further appreciation. This can be viewed as an opportunity cost.
Another limitation relates to the cost of the premiums. While the sale of the call option helps offset the cost of the put option, it may not always fully cover it, resulting in a net debit that reduces overall returns. Investors also need to consider the choice of strike prices and expiration date, as these significantly impact the risk-reward profile of the collar. Misjudging future volatility or the stock's price trajectory can lead to suboptimal outcomes. Furthermore, regulatory bodies like the SEC emphasize that investment professionals must adhere to standards of conduct when making recommendations, including considering the suitability and potential conflicts of interest for retail investors when advising on strategies like the collar1.
Collar vs. Covered Call
The collar strategy is often confused with a covered call because the latter is a component of the former. Both strategies involve owning shares of an underlying asset and selling call options against those shares to generate income. However, the key difference lies in the risk management provided.
A covered call provides limited downside protection, primarily through the premium received, which only offsets losses up to the amount of the premium. If the stock price falls significantly below the purchase price and the premium collected, the investor can incur substantial losses. In contrast, a collar adds the purchase of a put option. This put option explicitly defines and limits the maximum potential loss, providing a concrete floor below which the investor's loss will not extend, regardless of how far the stock price declines. While a covered call seeks to generate income and mildly mitigate risk, a collar prioritizes comprehensive downside protection, making it a more robust hedging tool.
FAQs
What is the main purpose of a collar strategy?
The main purpose of a collar strategy is to protect an existing stock position from significant downside price movements while also limiting potential upside gains. It's a risk management technique.
When should an investor consider using a collar?
An investor might consider using a collar when they own a stock they wish to hold long-term, but they are concerned about potential short-term price drops. It's particularly useful for protecting accumulated profits in highly appreciated stock positions or navigating periods of anticipated volatility.
Can a collar strategy result in a net cost?
Yes, a collar strategy can result in a net cost, or "net debit." This happens if the premium paid for the put option is higher than the premium received from selling the call option. In some cases, if the premiums balance out, it can be a "zero-cost collar."
Does a collar eliminate all risk?
No, a collar does not eliminate all risk. While it limits downside exposure, the investor still bears the risk of losses up to the put option strike price. Additionally, it introduces opportunity cost by capping upside potential.