If the market has not been volatile enough for you recently, add in quarterly earnings and you have even more potential volatility into the mix. If you own stock, you would love your stock to gap higher after the release. Unfortunately, that is not always the case. The way 2020 has progressed thus far, option traders should take nothing for granted. But this is where a collar could make sense, and like every other option strategy it comes with trade-offs.
A collar is having a stock position and buying a put option and selling a call option on the stock. Usually both the call and the put are out-of-the money (OTM) when establishing this option combination. One collar represents one long put and one short call along with 100 shares of the underlying stock. The main objective of a collar is to protect profits that have accrued from the shares of stock rather than increasing returns.
When to Use
An investor will usually implement a collar after accruing unrealized profits from shares of stock. Since the market has been on such a highly unusual bullish run, it might be a good time to talk about this strategy. By buying a put, the investor has some protection for the unrealized profits in case the stock declines. The other part of the combination is selling the OTM call. By doing this, the investor is prepared to sell his or her shares of stock if the call is exercised because the stock has moved above the call’s strike price.
The advantage of a collar over just buying a protective put is being able to finance some or all of the put by selling the call. In essence, an investor buys downside stock protection for free or almost free of charge. Until the investor exercises the put, sells the stock or has the call assigned, he or she will retain the stock.
Volatility and Time Decay
Implied volatility has been really low over the past several months in the market, but volatility and time decay are not usually big issues when it comes to collars. The main reason is because the investor is long one option and short another, so the effects of volatility and time decay will generally offset each other.
Here’s an Example
Let’s say an investor bought 100 shares of Apple Inc. (AAPL) at $100 a share. Now the stock has climbed to about $117 a share and has pulled back with this most recent decline. The investor is worried about the current market conditions and a pending earnings announcement next week. He or she would like to protect the unrealized gains as year-end approaches. The investor can consider utilizing a collar. Take a look below.
The investor can buy an Oct-30 113 put for 2.20. If the stock falls, the investor will have the right to sell the shares for $113. At the same time the investor can sell an Oct-30 121 call for 2.16. This will make the trade a net debit of 0.04 (2.20 – 2.16) or $4 in real terms. If the stock continues to rise, it can do so for about another $4 until the stock will most likely be called away from the investor.
Three Possible Outcomes
The stock finishes over $121 at Oct-30 expiration. If this scenario happens, another $4 ($400 in real terms for 100 shares) per share is realized on the stock and there’s a $4 loss on the net debit of the collar.
The stock finishes between $113 and $121 at Oct-30 expiration. In this case, both options expire worthless. The stock is retained and the $4 net debit is incurred because of the collar.
The stock finishes below $113 at Oct-30 expiration. The investor can sell the put option if he or she wishes to retain the stock or exercise the right to sell the stock at $113. Once again, the $4 loss is also incurred from the collar.
The nice thing about a collar strategy is that an investor knows the potential losses and gains right from the start. There is simply no guessing. To me, it makes sense to sleep and feel better at night instead of worrying about your position. Of course, there is a trade-off because your gains are limited due to the short call. To me, that is minor in comparison to having almost a safety net below the stock.
Senior Options InstructorSenior Options Instructor
Market Taker Mentoring, Inc.