by Amanda Harvey
A collar option is a hedging strategy that is used primarily to protect an investor’s position in the underlying stock. When a stock position has attained a substantial increase, a collar strategy may be implemented to minimize loss of profit in the event of a downturn. Undertaking this type of strategy involves the trade-off between some of the upside potential in return for offsetting the downside risk.
How is a Collar Option Constructed?
A collar strategy is executed by simultaneously buying a put option and selling or writing a call option on the underlying asset in which the investor wishes to protect their holding. Buying the put options means that if the price of the stock drops, the value of the option should increase, thereby offsetting any loss incurred by the holding of the underlying asset.
Without the simultaneous selling of the call option, this would simply constitute a protective put. The advantage of executing a collar option strategy by combining the protective put with the writing of a call option is that the cost of the premium for buying the put should be offset largely, if not fully, by the premium received for the call option. If the premium received from writing the call fully covers the cost of buying the put, this is known as a zero-cost collar.
To construct a collar option strategy, the investor normally uses put and call options that have the same expiration date, and are both out-of-the-money. The strike price for the call and put are typically equidistant from the price at which the stock is currently trading. For example, if a stock is trading at $20, the investor might create the collar using a put with a strike price of $15 and a call with a strike price of $25. The standard collar consists of one put and one call contract per one hundred shares held in the underlying stock.
While this hedging strategy is often implemented at a time when significant increase has been attained in the stock position, it may also be established at the same time as the investor enters the stock position, as a form of insurance.
What Are the Possible Outcomes of Using a Collar Option?
The first possible scenario is that the stock is still trading between the strike prices of $15 and $25 when the options reach their expiration, and therefore they are not exercised. In this situation, the only result of implementing the collar is that the investor absorbed any cost resulting if a higher premium was paid for the put options than was received for the call options.
The second potential outcome in this example is that the stock price has dropped below $15 at the time of expiry. In this event, the investor has two choices. One is to exercise the option and sell the shares at the strike price, thereby sustaining a loss of $5 per share in relation to the value that they has when the collar was implemented. However, they may have initially purchased the shares at even lower than this strike price, so there will possibly be a net profit, with the put option having functioned as somewhat of a ‘stop-loss.’ If they believe that the stocks will regain their former value, however, the investor may decide to hold the shares, and sell the put option contract at a higher premium than what they paid for it, helping to offset the current loss of value of the stock.
The third possible eventuality is that the stock price is above the call strike price of $25 when expiration is reached. In this case, the buyer of the call option may choose to exercise the option, and the investor is obligated to sell the shares at the strike price of $25. While the price may continue to rise and the investor is unable to hold onto their investment to capitalize on the further increase, this possible limit on increase is one of the trade-offs of entering a collar option strategy.
While there is the potential limit on profit involved in using a collar option, it is also an effective low- or even no-cost method of limiting possible loss on a stock investment. As with all option trading strategies, the investor needs to have a solid understanding of the logistics of the methods they wish to implement.