Collars

What Is Collars?

A collar is an options trading strategy employed by investors holding a long position in an underlying asset, typically a stock, to limit potential losses while also capping potential gains. This strategy falls under the broader category of options trading strategies and is often used to protect accumulated profits or mitigate risk in a volatile market. A collar essentially creates a defined range for the stock's price movement, providing a "collar" of protection. Investors implement a collar by simultaneously purchasing a protective put option and selling a covered call option on the same underlying asset.

History and Origin

The concept of options contracts dates back centuries, with early forms believed to exist in Ancient Greece for speculating on harvests. However, the modern, standardized options market began with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Cboe revolutionized financial markets by introducing standardized options contracts, which brought increased transparency and liquidity compared to earlier, unlisted over-the-counter options. The development of pricing models like Black-Scholes-Merton in 1973 also significantly contributed to the growth and acceptance of options trading, making it easier for investors to value these complex instruments. The creation of listed options at Cboe laid the foundation for sophisticated strategies like the collar, enabling investors to combine different options to manage risk more effectively.⁵

Key Takeaways

• A collar is an options strategy designed to protect a long stock position from significant downside risk.
• It involves simultaneously holding the underlying stock, buying a protective put option, and selling a covered call option.
• The strategy caps both potential losses (due to the put) and potential gains (due to the call).
• Selling the call option helps offset the cost of purchasing the put option, making it a cost-efficient hedging strategy.
• Collars are generally suitable for investors who anticipate moderate price movements or seek risk management without fully selling their stock.

Formula and Calculation

The maximum profit and maximum loss for a collar strategy can be calculated as follows, considering whether the strategy results in a net debit (cost) or a net credit (income) at initiation:

Net Debit/Credit Calculation:

Maximum Profit (if Net Debit):

Maximum Profit (if Net Credit):

Maximum Loss (if Net Debit):

Maximum Loss (if Net Credit):

The strike price of the put option determines the floor for potential losses, while the strike price of the call option sets the ceiling for potential gains. The premium paid or received for each option impacts the overall cost or income of the collar.

Interpreting the Collar

A collar strategy is interpreted as a method to define a specific range of outcomes for a stock position over a certain period. The chosen strike prices for the put and call options create boundaries for the stock's performance. For instance, if an investor establishes a collar with a put option at a strike price of $90 and a call option at a strike price of $110, they are essentially saying they are willing to accept losses below $90 but forgo gains above $110. This approach provides a clear risk-reward profile, limiting exposure to significant price declines while also limiting participation in substantial upside movements. It is particularly useful when an investor anticipates moderate price appreciation or sideways movement in the market conditions but wants to protect existing unrealized gains. The effectiveness of the collar depends heavily on careful selection of strike prices and expiration dates.

Hypothetical Example

Consider an investor who owns 100 shares of XYZ stock, currently trading at $100 per share. The investor is concerned about potential short-term volatility but does not want to sell their shares. They decide to implement a collar strategy.

1. Long Stock Position: 100 shares of XYZ stock at $100 per share (Total value: $10,000).
2. Buy Protective Put: The investor buys one XYZ $95 put option, expiring in three months, for a premium of $2.00 per share ($200 total for 100 shares). This put option gives them the right to sell their shares at $95.
3. Sell Covered Call: Simultaneously, the investor sells one XYZ $105 call option, expiring in three months (same expiration as the put), for a premium of $2.50 per share ($250 total for 100 shares). This obligates them to sell their shares at $105 if the call is exercised.

Net Cost/Credit: The investor receives $250 from selling the call and pays $200 for buying the put, resulting in a net credit of $50 ($250 - $200).

Outcome Scenarios in Three Months:

• XYZ stock closes at $110: The $105 call option is in-the-money and is exercised. The investor is obligated to sell their shares at $105. Their profit from the stock is $5 per share ($105 - $100), plus the initial $0.50 net credit, totaling $5.50 per share, or $550. The $95 put option expires worthless.
• XYZ stock closes at $98: Both options expire out-of-the-money and worthless. The investor still owns the stock, which is now worth $98 per share. Their loss on the stock is $2 per share ($100 - $98), but this is offset by the $0.50 net credit from the collar, resulting in a net loss of $1.50 per share, or $150.
• XYZ stock closes at $90: The $95 put option is in-the-money and exercised. The investor sells their shares at $95. Their loss on the stock is $5 per share ($100 - $95), but this is offset by the $0.50 net credit, resulting in a net loss of $4.50 per share, or $450. The $105 call option expires worthless.

In this example, the collar successfully limited the downside loss to $4.50 per share and capped the upside gain to $5.50 per share, demonstrating its effectiveness as a risk management tool.

Practical Applications

Collars are widely used in various investment scenarios, particularly by individuals and institutions looking to manage exposure to existing equity holdings. One common application is for investors who hold a significant, appreciated stock position and wish to protect unrealized gains without selling the shares outright, which might trigger tax implications. By using a collar, they can establish a floor for the stock's price, ensuring that if the market experiences a downturn, their losses are limited.

Furthermore, collars are employed in periods of market uncertainty or high volatility, where investors seek to mitigate potential drawdowns. For example, during times of rising global trade tensions or concerns over fiscal debt, investors may turn to strategies that offer a degree of safety for their portfolios.⁴ This allows them to maintain their long-term conviction in the underlying asset while providing short-term protection. The sale of the call option helps finance the purchase of the protective put, making this hedging strategy more cost-effective than simply buying a put option alone.

Limitations and Criticisms

While collars offer valuable risk management benefits, they come with notable limitations. The primary criticism is that they cap the upside potential of the underlying stock. If the stock's price surges significantly above the call option's strike price, the investor's gains are limited to that strike price, effectively preventing them from participating in further appreciation. This trade-off between downside protection and capped upside is inherent to the strategy.³

Another limitation is that collars require active management. Investors need to choose appropriate strike prices and expiration dates and monitor their positions as the expiration approaches. If the stock price approaches either strike, decisions about rolling or closing the positions need to be made. While often presented as a low-cost or even credit-generating strategy, collars are not entirely free; commission costs apply, and there's the opportunity cost of foregone upside. The strategy might also be less effective in rapidly declining markets if the selected put strike price is too far out-of-the-money to provide adequate protection, or if the initial stock price significantly drops below the chosen put strike.²

Collars vs. Covered Calls

While closely related, collars and covered calls serve distinct purposes in options trading strategies. Both involve holding a long position in an underlying asset and selling a call option against it to generate premium income. However, the key differentiator is the inclusion of a protective put option in a collar.

A covered call provides income but offers no explicit downside protection beyond the initial premium received. A collar, by adding the protective put, transforms the strategy into a defined-risk position, where both potential gains and losses are bounded. Investors often use covered calls when they are moderately bullish or neutral on a stock and primarily seek income, whereas collars are favored when there's concern about a potential decline but a desire to retain the stock.

FAQs

1. What is the main purpose of a collar strategy?

The main purpose of a collar strategy is to protect an existing long stock position from significant downside price movements, effectively setting a floor on potential losses. It also helps offset the cost of this protection by generating income from selling a call option.

2. How does a collar differ from simply buying a put option?

While buying a protective put also offers downside protection, a collar integrates the sale of a covered call to help finance the cost of the put. This makes the collar a more cost-efficient hedging strategy, though the trade-off is that it caps potential upside gains.

3. Can I use a collar on any stock?

A collar can generally be used on any stock for which listed options are available. It is most commonly applied to stocks that an investor owns and wishes to protect, particularly those with significant unrealized gains.

4. What happens if the stock price rises significantly with a collar in place?

If the stock price rises significantly above the strike price of the sold call option, that call option will likely be in-the-money and exercised. This means the investor will be obligated to sell their shares at the call option's strike price, thereby capping their maximum profit, regardless of how much higher the stock price goes.

5. Are collars suitable for beginners?

Collars involve combining multiple derivatives (options), which adds complexity compared to simply buying and selling stocks. While beneficial for risk management, understanding the intricacies of option premiums, strike prices, and expiration dates is crucial. It is recommended for investors to have a solid grasp of basic options concepts before implementing a collar strategy. The U.S. Securities and Exchange Commission (SEC) provides introductory information for investors considering options.¹