Collar strategy

Hidden table:

What Is Collar Strategy?

A collar strategy is an options trading strategy that involves holding a long position in an underlying asset while simultaneously buying a protective put option and selling a covered call option. This strategy is designed to limit potential losses on an existing stock holding while also capping potential gains. It falls under the broader category of derivatives and options trading strategies, as it uses financial contracts whose value is derived from an underlying asset.

The core purpose of a collar strategy is to define a range for potential profits and losses, providing a measure of risk management.³⁷ By buying a put option, an investor establishes a floor, protecting against significant market downturns.³⁶ The sale of a call option helps offset the cost of the put option and sets a ceiling on the maximum profit.³⁵

History and Origin

The concept of using options to manage risk has ancient roots, with the earliest known example attributed to the Greek philosopher Thales of Miletus in the 6th century BC. He reportedly secured the right to use olive presses, effectively creating a call option, to profit from an anticipated abundant olive harvest.³³, ³⁴

However, the modern era of options trading, and by extension, strategies like the collar, began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973.³² Before the CBOE, options were primarily traded over-the-counter (OTC) with complex, non-standardized terms. The CBOE introduced standardized, exchange-traded options contracts, significantly enhancing transparency and liquidity in the market.³⁰, ³¹ This standardization paved the way for more sophisticated options strategies, including the development and widespread adoption of the collar strategy by institutional investors and money managers seeking to hedge large stock positions against market corrections.²⁹

Key Takeaways

• A collar strategy combines a long position in an underlying asset with the simultaneous purchase of a put option and sale of a call option.²⁸
• Its primary goal is to provide downside protection for a stock while limiting potential upside gains.
• The premium received from selling the call option can help offset the cost of buying the protective put.²⁷
• This strategy is often employed by investors who are moderately bullish or neutral on a stock but seek to manage short-term market volatility.
• While offering defined risk and reward, it caps potential profits, which can be a disadvantage in strong bull markets.²⁶

Formula and Calculation

The profit and loss for a collar strategy can be calculated based on the stock price at expiration relative to the strike prices of the options.

Let:

• (S_0) = Initial stock price
• (S_T) = Stock price at expiration
• (P_p) = Premium paid for the put option
• (P_c) = Premium received from selling the call option
• (K_p) = Strike price of the put option
• (K_c) = Strike price of the call option

The maximum profit from a collar strategy is capped. It is achieved when the stock price at expiration is at or above the call option's strike price:

[
\text{Max Profit} = (K_c - S_0) + (P_c - P_p)
]

The maximum loss from a collar strategy is limited to the put option's strike price. It occurs when the stock price at expiration is at or below the put option's strike price:

[
\text{Max Loss} = (S_0 - K_p) + (P_p - P_c)
]

The breakeven point for a collar strategy is the initial stock price plus the net premium paid (or minus the net premium received):

[
\text{Breakeven Point} = S_0 + P_p - P_c
]

It is important to note that the values of the put option and call option premiums are crucial inputs for these calculations.

Interpreting the Collar Strategy

The collar strategy creates a "collar" or "band" around the underlying asset's price, establishing a defined range for potential returns. Investors interpret this strategy as a trade-off between downside protection and upside potential. If an investor expects moderate price movements or is concerned about short-term market volatility, the collar can be an effective tool.²⁵

The decision to implement a collar often reflects a desire to protect accumulated unrealized gains in a long position. By setting a lower bound with the protective put, the investor gains peace of mind against significant drops.²⁴ The sale of the covered call, while generating income to offset the cost of the put, signifies a willingness to forgo substantial upside beyond the call's strike price.²³ Therefore, the collar is best interpreted as a defensive strategy for capital preservation rather than an aggressive growth strategy. It is particularly relevant in fluctuating markets or for investors seeking to maintain stability in their portfolio.²²

Hypothetical Example

Consider an investor, Sarah, who owns 100 shares of XYZ Corp., currently trading at $100 per share. She bought these shares at $80, so she has an unrealized gain. Sarah is optimistic about XYZ's long-term prospects but is concerned about potential short-term market volatility due to an upcoming earnings report. She decides to implement a collar strategy.

1. Own the Underlying Asset: Sarah already owns 100 shares of XYZ Corp. at $100 per share.
2. Buy a Protective Put: Sarah buys one out-of-the-money (OTM) put option with a strike price of $95, expiring in three months. The premium for this put option is $3 per share, totaling $300 for 100 shares. This establishes a floor at $95, meaning her loss below $95 per share is capped.
3. Sell a Covered Call: Simultaneously, Sarah sells one OTM call option with a strike price of $105, also expiring in three months. The premium received from selling this call option is $2 per share, totaling $200 for 100 shares. This caps her potential upside at $105 per share.

Net Cost of the Collar: Sarah's net debit for the collar is the cost of the put ($300) minus the premium from the call ($200), resulting in a net cost of $100.

Scenario 1: Stock price increases to $110 at expiration.

• Sarah's stock is worth $11,000.
• The $95 put option expires worthless.
• The $105 call option is in-the-money. The buyer of the call will exercise it, and Sarah will be obligated to sell her 100 shares at $105 each, totaling $10,500.
• Her profit from the stock is $10,500 (sale price) - $8,000 (original purchase) = $2,500.
• Subtracting the net cost of the collar ($100), her total profit is $2,400. Her profit is capped at the call's strike price minus the initial purchase price, adjusted for the net premium.

Scenario 2: Stock price decreases to $90 at expiration.

• Sarah's stock is worth $9,000.
• The $95 put option is in-the-money. Sarah can exercise it and sell her 100 shares at $95 each, totaling $9,500.
• The $105 call option expires worthless.
• Her loss on the stock, if not for the put, would have been $10,000 - $9,000 = $1,000.
• With the put, her effective selling price is $95 per share. Her loss from the original $100 market value is $5 per share, or $500 total.
• Adding the net cost of the collar ($100), her total loss from the original $100 market value is $600. Her loss is limited to the initial stock price minus the put's strike price, adjusted for the net premium.

This example illustrates how the collar strategy effectively limits both Sarah's downside risk and her potential for large gains, providing a defined range of outcomes.

Practical Applications

The collar strategy is a versatile tool with several practical applications across various financial contexts. It is primarily used for hedging existing long positions, offering a balance between risk management and the potential for continued, albeit limited, upside participation.²¹

One common application is by institutional investors, such as pension funds or endowments, who hold large, concentrated stock positions and seek to protect accumulated gains without fully liquidating their holdings.²⁰ For example, a pension plan might use an equity collar to guard against a significant market drawdown while still allowing for positive returns within a specified range.¹⁹ Companies also employ hedging strategies, including options, to manage various risks, such as interest rate fluctuations or commodity price volatility.¹⁷, ¹⁸

Additionally, high-net-worth individuals or retirees may use collar strategies to safeguard their portfolios during periods of market uncertainty.¹⁶ By combining a protective put with a covered call, they can generate income to offset the cost of the downside protection, making it a cost-effective way to reduce portfolio volatility.¹⁵ This approach can be particularly beneficial for preserving income when nearing or in retirement, as it establishes predictable boundaries for profits and losses.¹⁴

Limitations and Criticisms

While the collar strategy offers valuable risk management, it is not without limitations and criticisms. A primary drawback is that it caps the investor's upside potential. If the underlying asset experiences a significant price surge above the call option's strike price, the investor's profits are limited to that strike price, minus any net premium paid.¹³ This means foregoing potentially substantial gains that an unhedged long position might capture.¹²

Another criticism is the inherent trade-off between protection and cost. While the premium generated from selling the call option is intended to offset the cost of the put option, it may not always fully cover it, resulting in a net debit for the strategy.¹¹ Furthermore, the effectiveness of a collar can be impacted by market volatility. In highly volatile markets, the cost of protective puts can increase, making the strategy more expensive to implement.¹⁰

Some academic analyses suggest that, historically, the collar strategy may be a relatively poor performer compared to other methods of reducing downside risk, such as simply selling equity or buying only a put option.⁸, ⁹ This underperformance can be attributed to the collar earning less equity risk premium.⁷ The complexity involved in selecting appropriate strike prices and expiration dates for the options, as well as the need for continuous monitoring and potential adjustments, can also be a challenge for less experienced investors.⁶ Early assignment risk, where the sold call option is exercised prematurely, can also disrupt the strategy and lead to unintended tax consequences.⁴, ⁵

Collar Strategy vs. Protective Put

The collar strategy and the protective put are both options strategies used for risk management, particularly to protect a long position in an underlying asset. However, they differ significantly in their construction, cost, and impact on potential returns.

A protective put involves holding a long position in a stock and simultaneously buying a put option on that same stock. Its sole purpose is to provide downside protection; if the stock price falls below the put's strike price, the investor's loss is limited to that point. The primary advantage is unlimited upside potential. The main disadvantage is the direct cost of the put option premium, which can be substantial, especially for longer durations or in volatile markets.

In contrast, a collar strategy builds upon the protective put by adding the sale of a call option. While it still offers downside protection, the premium generated from selling the call option helps offset the cost of the put option, potentially making it a "zero-cost collar" or reducing the net debit. However, this cost reduction comes at the expense of capping potential upside gains. If the stock price rises above the call's strike price, the investor is obligated to sell the stock at that price, forfeiting any further appreciation. Therefore, while a protective put offers pure downside insurance at a direct cost, a collar provides a more cost-efficient form of protection by trading away some of the upside.

FAQs

What is the main purpose of a collar strategy?

The main purpose of a collar strategy is to protect an existing long position in an asset from significant downside risk while also helping to offset the cost of that protection. It is a form of hedging against potential price declines.

How does a collar strategy limit both gains and losses?

A collar strategy limits losses by the purchase of a put option, which sets a floor below which the asset's value will not fall. It limits gains by the simultaneous sale of a call option, which obligates the investor to sell the asset at a predetermined strike price if the market price rises above it.

When is the best time to use a collar strategy?

A collar strategy is typically used when an investor owns a stock that has appreciated in value and they want to protect those unrealized gains, but they are concerned about potential short-term market downturns or increased market volatility. It's suitable for investors who are moderately bullish or neutral on the stock's near-term prospects.³

Can a collar strategy be "zero-cost"?

Yes, a collar strategy can be structured as "zero-cost" if the premium received from selling the call option is equal to or greater than the premium paid for the put option. This offsets the cost of the downside protection, though it still caps potential upside.

Is a collar strategy suitable for all investors?

The collar strategy is generally considered suitable for investors who understand options trading and its complexities. It requires active risk management and monitoring, and it may not be ideal for investors seeking unlimited upside potential in their portfolio or those new to options.¹, ²