A collar is an options strategy that involves the purchase of a put option and the sale of a call option on the same pre-owned underlying stock. The call and put do not have the same strike price (the call is always at a higher strike than the put), nor must they necessarily have the same expiration date.
In essence, the collar trader uses the proceeds from the sale of the call to finance the purchase of the put. Those with large holdings in a particular stock will buy puts to lock in a “minimum sale price,” thereby insuring against a plunge in the stock. They do this in a relatively inexpensive manner, using the premium collected from the call sale to buy the put. However, this supposedly "free" insurance does not come without a cost. In this particular strategy, the cost (in addition to the net debit) is capping the profit potential on one’s stock holding.
In order to insure an adequate risk-to-reward profile, those employing a collar strategy will generally sell a further out-of-the-money call than the purchased put, thereby allowing the collar player more upside potential than downside risk. Although the call and put balance each other out in terms of market direction, the long position already held in the trader’s portfolio gives the position a slightly bullish bias. If the investor were overtly bearish on the stock, he could sell the stock outright or buy a lone put.
Let’s say a trader has owned 100 shares of stock XYZ for a couple of months and it’s gained some ground. She now wants to protect those gains with a put, but doesn’t want to pay the full price. At the same time, she’s willing to sell the stock at a price higher than the current market price.
XYZ is trading at 76 and though it’s declined during the past week, the trader remains bullish, believing it may recover and advance about 5 to 10% before May expiration. The trader establishes a collar by selling 1 XYZ May 85 call at $3 and buying 1 XYZ May 70 put at $3, thus creating a net cost of zero. Remember, the goal of a collar is to insure the investment at little to no cost. Thus, the sale of the call subsidizes the protection offered by the put purchase.
With the stock between 70 and 85, both options are out of the money and will expire worthless. Thus, the position’s value is dictated solely by the price of the stock, and will range from -6 (at 70) to +9 (at 85). The trader retains ownership of the stock and can either hold, sell, or hedge again with another collar.
Below a stock price of 70, the purchased put will increase in value, negating any further downside in the stock. In other words, the loss (akin to the deductible of an insurance policy) is limited to -6 because of the put.
At a stock price above 85, the written call will gain in value since it will become in the money. The increasing liability for this call will exactly counteract the increase in the stock price. Thus, the net effect of the written call is to cap the maximum gain at +9 at all stock prices at or above 85.
The bonus to a collar trader is his limited maximum loss. In large part, this benefit is an emotional one. That is, the trader is not faced with a "hold or sell" decision should the stock begin to decline, as a put is in place to guard against a hefty loss should the equity tumble precipitously.
With the collar in effect, though, the trader still stands to benefit to some extent if the held stock rallies upward after the collar is initiated. The put that was purchased gives the holder the right, but not the obligation, to sell the shares at the strike price at which the put option was purchased. If one is able to sell the stock above market value after a big decline, the decision when and if to exercise the option can be made with a clearer mind, especially if the breach of the purchased strike occurs prior to expiration and if the holder of the stock has nothing but upside potential until expiration.
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