How Do Option Collars Work?

Posted on Wednesday, March 27, 2019 at 1:10 PM

The market has been on some run since the holidays. After investors were worried that stocks would continue to sink into 2019, many stocks have recovered quite nicely. If you are a smart investor and know what an option collar is, the threat of another decline is not as scary. If you don’t know what a collar is and you own stock, now may be the time to learn.

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.

An investor will usually implement a collar after accruing unrealized profits from shares of stock. Just like everything in option trading, there are pros and cons to collars too. Selling a call option limits gains to the upside like a covered call if the stock moves past the call strike by using the premium received from the sold (short) call to partially or fully fund the long put. The position does not profit exactly like just a covered call would.
   
Let’s take a look at a quick example. Say you bought this stock when it traded above its 200-day moving average. You purchased 100 shares for $170. The stock currently closed at $182.14 as seen below.

A profit of $12.14 (182.14 – 170) is currently realized. What if you are nervous that either the stock will gap down again as it did recently or that the overall market may decline? This is where an options collar may help. Take a look at the option chain below.

You could sell the 187.5 call for a credit of 2.64 and buy a 177.5 put for 2.99 with about 30 days to go until expiration. The net result of the collar is a debit of 0.35 (2.99 – 2.64) or $35 in real terms. Now the position is protected if it falls past $177.50 (because the 177.5 put strike) until expiration for a small debit. The long put allows the shares to be sold at $177.50.

The position is now limited to gains of up to $187.50 (short call strike) until expiration because of the short call. If the stock closes between the two strikes (177.50 and 187.50), shares are retained and the loss of $35 for the collar is realized. It was the price of protection.

The one thing about an option collar is that an investor knows the potential losses and gains right from the start. There simply is no guessing. If the stock climbs higher, the profits may be cut off because of the short. If the stock moves lower, the investor has protection due to the long put.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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