What Is a Collar Option Strategy and How Does It Work?

When I think of collars as an option trader, I think of sleeping better at night. Option collars can potentially protect a stock position in case the position declines. Like everything that involves options, there are trade-offs too. Collars cannot work miracles, but they do have their benefits as well as their limitations. Let’s take a look at the definition of a collar and several considerations when using the strategy.

Collar Definition

A collar is an often misunderstood but rather simple option strategy that can particularly benefit investors. 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 options 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. In addition, he or she can implement a collar even without accrued gains in a volatile environment. Another time to consider a collar is when the market and/or the underlying has been on bullish run. 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.

Advantages

The major advantage of a collar over just buying a protective put (a long put) is being able to finance some or the entire put by selling the call. In essence, an investor buys downside stock protection for free or almost free. There is a trade-off between premium and how close the call and put strikes are to the underlying. The more wiggle room you sell your covered call strike at or the shorter the expiration, the less premium collected. That means less premium to apply to the long put, and maybe the long put strike will be lower and thus allow for a greater potential loss if the underlying does drop. Trade-offs abound for investors between protection, upside potential and premium. 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 that being said, volatility and time decay are not usually big issues when it comes to collars. The main reason is the investor is long one option and short another (positive and negative for vega and theta), so the effects of volatility and time decay will generally offset each other.

Three Possible Outcomes

Let’s pretend you bought 100 shares of ABC at the beginning of the year for $46 a share. As luck and fortune would have it, the stock has climbed to $63 a share and has almost rallied into some potential resistance around the $65 level. You may be concerned the stock will pull back based on that potential resistance. You may be inclined to protect the unrealized gains just in case. This may be the perfect time to consider utilizing a collar.
 
You can buy a July 60 put for 2.00. If the stock falls, you will have the right to sell the shares for $60 or just sell the put. At the same time, you can sell a July 65 call for 2.50, which lines up with the potential resistance. This will make the trade a net credit of 0.50 (2.50 – 2). If the stock continues to rise, it can do so for another $2 until the stock will most likely be called away.

Let’s take a look at the three “options” so to speak in this collar:

  • The stock finishes over $65 at July expiration. If this scenario happens, another $2 per share is realized on the stock and $50 on the net credit of the combination is yours to keep.
  • The stock finishes between $60 and $65 at July expiration. In this case, both options expire worthless. The stock is retained and the $50 net credit is yours to keep as well.
  • The stock finishes below $60 at July expiration. You have the right to sell the put option if you wish to retain the stock or exercise the right to sell the stock at $60. Either way the $50 net credit is yours to keep once more.
Conclusion

I have made no bones about how much I think investors should have collars in their arsenal. Like every option strategy out there, there are pros and cons. But to me, a peaceful night’s sleep is usually well worth the trade-off.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.