A collar is an options trading strategy
that is constructed by holding shares of the underlying stock while
simultaneously buying protective puts and selling call
options against that holding. The puts and the calls are both out-of-the-money
options having the same expiration month and must be equal in number of
contracts.
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Collar
Strategy Construction
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Long 100 Shares
Sell 1 OTM Call Buy 1 OTM Put |
Technically, the collar strategy is the
equivalent of a out-of-the-money covered call strategy with the
purchase of an additional protective put.
The collar is a good strategy to use if
the options trader is writing covered calls to earn premiums but wish to
protect himself from an unexpected sharp drop in the price of the underlying
security.
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Collar Strategy Payoff Diagram
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Limited Profit Potential
The formula for calculating maximum
profit is given below:
- Max Profit
= Strike Price of Short Call - Purchase Price of Underlying + Net Premium
Received - Commissions Paid
- Max Profit
Achieved When Price of Underlying >= Strike Price of Short Call
Limited Risk
The formula for calculating maximum
loss is given below:
- Max Loss =
Purchase Price of Underlying - Strike Price of Long Put - Net Premium
Received + Commissions Paid
- Max Loss
Occurs When Price of Underlying <= Strike Price of Long Put
Breakeven Point(s)
The underlier price at which break-even
is achieved for the collar strategy position can be calculated using the
following formula.
- Breakeven
Point = Purchase Price of Underlying + Net Premium Paid
Example
Suppose an options trader is holding
100 shares of the stock XYZ currently trading at Rs48 in June. He decides to
establish a collar by writing a JUL 50 covered call for Rs2 while
simultaneously purchases a JUL 45 put for Rs1.
Since he pays Rs4800 for the 100 shares
of XYZ, another Rs100 for the put but receives Rs200 for selling the call
option, his total investment is Rs4700.
On expiration date, the stock had
rallied by 5 points to Rs53. Since the striking price of Rs50 for the call
option is lower than the trading price of the stock, the call is assigned and
the trader sells the shares for Rs5000, resulting in a Rs300 profit (Rs5000
minus Rs4700 original investment).
However, what happens should the stock
price had gone down 5 points to Rs43 instead? Let's take a look.
At Rs43, the call writer would have had
incurred a paper loss of Rs500 for holding the 100 shares of XYZ but because of
the JUL 45 protective put, he is able to sell his shares for Rs4500 instead of Rs4300.
Thus, his net loss is limited to only Rs200 (Rs4500 minus Rs4700 original
investment).
Had the stock price remain stable at Rs48
at expiration, he will still net a paper gain of Rs100 since he only paid a
total of Rs4700 to acquire Rs4800 worth of stock.
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