Price collars

Price Collars

Price collars are a defensive options strategy categorized under options strategies designed to protect an investor's gains in a long position while simultaneously capping potential upside. A price collar involves holding a long position in an underlying asset, typically shares of equity, and simultaneously buying an out-of-the-money put option and selling an out-of-the-money call option on the same asset. This combination creates a price range, or "collar," within which the investor's profit or loss is contained. The strategy aims to limit downside risk management by setting a floor on potential losses, while the sale of the call option helps to offset the cost of purchasing the put option.

History and Origin

The concept of options, the foundational components of price collars, has a long history, with early forms of contracts resembling modern options dating back to ancient Greece, exemplified by Thales of Miletus's use of olive press rights. Informal options trading also occurred during the Dutch Tulip Mania in the 17th century and in London coffee houses in the 18th and 19th centuries. The modern era of standardized options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in April 1973, which introduced a formal marketplace for listed options and facilitated the growth of sophisticated options strategies. The CBOE's founding, alongside the creation of the Options Clearing Corporation (OCC) in the same year, provided the infrastructure for a regulated and efficient options market.¹⁰, ¹¹, ¹² This standardization, coupled with the development of pricing models like the Black-Scholes model, significantly expanded the accessibility and application of derivatives for both hedging and speculation.⁸, ⁹ The evolution of structured options markets, as documented by Cboe Global Markets, paved the way for complex, multi-leg strategies like price collars.⁷

Key Takeaways

A price collar is a defensive options strategy used to protect gains in a long stock position.
It involves buying a put option and selling a call option on the same underlying asset.
The strategy sets a floor for potential losses and a ceiling for potential gains, "collaring" the price.
The premium received from selling the call option can help offset the cost of buying the put option.
Price collars are typically employed when an investor is moderately bullish or neutral on an asset but wants to hedge against significant downside risk.

Formula and Calculation

The primary financial outcome for a price collar can be expressed in terms of its net cost or credit, maximum profit, and maximum loss.

Net Cost/Credit of the Collar:
The initial outlay or inflow for establishing a price collar is the net premium paid or received.
$\text{Net Cost/Credit} = \text{Premium Paid for Put} - \text{Premium Received from Call}$

If the result is positive, it's a net cost (debit).
If the result is negative, it's a net credit.

Maximum Profit (if the collar is initiated for a net debit):
$\text{Max Profit} = (\text{Call Strike Price} - \text{Original Stock Purchase Price}) - \text{Net Debit}$

Maximum Profit (if the collar is initiated for a net credit or zero cost):
$\text{Max Profit} = (\text{Call Strike Price} - \text{Original Stock Purchase Price}) + \text{Net Credit}$

Maximum Loss (if the collar is initiated for a net debit):
$\text{Max Loss} = (\text{Original Stock Purchase Price} - \text{Put Strike Price}) + \text{Net Debit}$

Maximum Loss (if the collar is initiated for a net credit or zero cost):
$\text{Max Loss} = (\text{Original Stock Purchase Price} - \text{Put Strike Price}) - \text{Net Credit}$

Here, the "Original Stock Purchase Price" refers to the price at which the underlying stock was initially acquired. The strike price of the options determines the boundaries of the collar.

Interpreting the Price Collar

Interpreting a price collar involves understanding the risk-reward profile it creates for a long position. The strategy effectively defines a range for potential profits and losses. The put option acts as insurance, setting a floor below which the investor's losses on the stock cannot fall. This is crucial for hedging against significant market downturns or unexpected negative news for the company. Conversely, the sale of the call option establishes a ceiling on potential gains; if the underlying asset's price rises above the call's strike price, the investor's upside is capped at that level.

The primary benefit of a price collar is the balance it strikes between protection and cost. The premium received from selling the call option often reduces or entirely offsets the premium paid for the protective put, making it a cost-efficient form of portfolio protection. Investors typically use price collars when they have a substantial unrealized gain in a stock they wish to continue holding but are concerned about short-term volatility or potential pullbacks in the market.

Hypothetical Example

Consider an investor who owns 100 shares of Company XYZ stock, purchased at $100 per share, which is now trading at $120 per share. The investor wants to protect their unrealized gains but believes the stock's upward movement might be limited in the short term.

To implement a price collar, they take the following steps (assuming one option contract covers 100 shares):

Buy a Protective Put: The investor buys one XYZ put option with a strike price of $115, expiring in three months, for a premium of $3.00 per share ($300 per contract). This sets a floor at $115, meaning their loss on the stock portion cannot exceed $5 per share below the current price ($120 - $115 = $5, plus the net cost of the collar).
Sell a Covered Call: Simultaneously, the investor sells one XYZ call option with a strike price of $125, expiring in three months, for a premium of $2.00 per share ($200 per contract).

Initial Cost/Credit:
Net cost for the collar = Premium paid for put ($3.00) - Premium received from call ($2.00) = $1.00 per share, or $100 for the contract.

Outcomes at Expiration:

If XYZ closes at $110 (below put strike): The put option is in-the-money, allowing the investor to sell their shares at $115. The call option expires worthless.
- Value of stock if sold at put strike: $115 per share.
- Initial stock value: $100 per share.
- Gain on stock position: $115 - $100 = $15 per share.
- Net cost of collar: -$1.00 per share.
- Total profit: $15 - $1.00 = $14.00 per share, or $1,400.
- This caps losses relative to the current market price (from $120 to $115) to $5 per share, plus the collar cost.
If XYZ closes at $122 (between strikes): Both options expire worthless. The investor keeps their shares and the stock's value.
- Current stock value: $122 per share.
- Initial stock value: $100 per share.
- Gain on stock position: $122 - $100 = $22 per share.
- Net cost of collar: -$1.00 per share.
- Total profit: $22 - $1.00 = $21.00 per share, or $2,100.
If XYZ closes at $130 (above call strike): The call option is in-the-money, and the investor's shares are called away at $125. The put option expires worthless.
- Value of stock if called away at strike: $125 per share.
- Initial stock value: $100 per share.
- Gain on stock position: $125 - $100 = $25 per share.
- Net cost of collar: -$1.00 per share.
- Total profit: $25 - $1.00 = $24.00 per share, or $2,400.
- This demonstrates that profits are capped at the call option's strike price.

Practical Applications

Price collars are commonly used in risk management by investors and portfolio managers, particularly those with significant unrealized gains in a stock they wish to hold for the long term but fear a short-term correction. This strategy allows them to secure a portion of their profits without selling the underlying shares, which can be beneficial for tax considerations or maintaining ownership in a company they believe in fundamentally.

For instance, an investor might use a price collar to protect the value of a concentrated stock position ahead of a known binary event, such as an earnings announcement or a regulatory decision, where significant volatility is expected. Corporations also sometimes use variations of collar strategies to manage exposure to commodity prices, interest rates, or foreign exchange risks. The sale of the call option within the collar structure can also help generate income, potentially offsetting the cost of the protective put and thus reducing the overall cost of the hedging strategy.⁶ Financial regulatory bodies like FINRA impose rules, such as FINRA Rule 2360, that govern the trading of options, ensuring proper disclosure and suitability for investors engaged in such strategies.⁵

Limitations and Criticisms

While price collars offer effective hedging against downside risk, they come with notable limitations. The most significant drawback is the capping of potential upside profit. By selling a call option, the investor forfeits any gains on the underlying asset beyond the call's strike price. This means that if the stock experiences a significant rally, the investor's profit will be limited to the difference between the call strike and their original purchase price (adjusted for the net cost/credit of the collar), potentially leading to missed opportunities compared to simply holding the stock unprotected.³, ⁴

Another consideration is the cost of the put option, which, while often offset by the call's premium, still represents a transaction cost. If the market conditions are particularly volatile, the price of the protective put may be high, making the collar more expensive to implement or requiring a lower call strike to achieve a zero-cost collar, thereby further restricting upside.² Additionally, the strategy requires ongoing management; investors must decide whether to roll, adjust, or close the positions as expiration approaches or if market views change. There is also the risk of early assignment of the call option, which can occur if the call is deep in-the-money, potentially disrupting the intended duration of the collar strategy.¹

Price Collars vs. Covered Call

Price collars and covered calls are both options strategies that involve holding a long position in an underlying asset and selling a call option against it. However, a key difference lies in the level of downside protection.

A covered call involves owning shares of stock and selling a call option to generate income from the premium. While it provides some buffer against minor declines (up to the premium received), it offers no protection against significant drops in the stock price below the initial purchase price. The primary goal of a covered call is often income generation or a slight reduction in cost basis, assuming a neutral to moderately bullish outlook.

A price collar, on the other hand, adds a protective put to the covered call structure. By purchasing a put option, the investor establishes a floor below which their losses on the stock cannot fall. This makes the price collar a true hedging strategy, prioritizing capital preservation over maximizing income or uncapped upside. While both strategies cap potential gains at the call option's strike price, the price collar provides explicit downside protection that the covered call lacks.

FAQs

What is the main purpose of a price collar?

The main purpose of a price collar is to protect unrealized gains in a long position in an underlying asset by setting a floor on potential losses, while simultaneously offsetting the cost of that protection by selling a call option.

Are price collars suitable for all market conditions?

Price collars are most suitable when an investor is moderately bullish or neutral on an asset but anticipates potential short-term volatility or minor declines. They are less suitable if the investor expects a significant upward price movement, as the strategy caps potential gains.

Can a price collar be established for zero net cost?

Yes, a "zero-cost collar" can be achieved if the premium received from selling the call option is equal to or greater than the premium paid for the put option. This is done by adjusting the strike prices and expiration dates of the options.

What happens if the stock price falls significantly below the put option's strike price?

If the stock price falls below the put option's strike price, the put option will be in-the-money. The investor can then exercise the put, selling their shares at the put's strike price, thereby limiting their maximum loss on the position.

Does a price collar eliminate all risk?

No, a price collar reduces but does not eliminate all risk. While it sets a floor for losses, the investor still bears the risk of the stock declining to the put option's strike price and loses the opportunity for significant upside gains beyond the call option's strike price. Transaction costs and the risk of early assignment also remain.