Consider a Collar as an Investor

Posted on Thursday, August 1, 2019 at 4:22 PM

Although this last round of quarterly earnings is almost in the books, I feel the need to remind investors that options can provide protection even when earnings season is not going on. Let’s face it, the market is going to move lower like it did suddenly last Thursday, so it may be time to take a look again at a potential protection strategy using options.

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 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 idea to consider them. 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 advantage of a collar over just buying a protective 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. 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:

An investor bought 100 shares of XYZ at the beginning of the year for $26 a share. Now the stock has climbed to $43 a share and has pulled back. The investor is worried about the current market conditions, and maybe a pending earnings announcement. He or she would like to protect the unrealized gains as year-end approaches. The investor can consider utilizing a collar.
 
The investor can buy an August 40 put for 2.00. If the stock falls, the investor will have the right to sell the shares for $40. At the same time the investor can sell an August 45 call for 2.50. 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 from him or her.

Three Possible Outcomes

The stock finishes over $45 at August expiration. If this scenario happens, another $2 per share is realized on the stock and $50 on the net credit of the combination is the investors to keep.
 
The stock finishes between $40 and $45 at August expiration. In this case, both options expire worthless. The stock is retained and the $50 net credit is the investors to keep.
 
The stock finishes below $40 at August 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 $40. Either way the $50 net credit is the investors to keep.

Conclusion

You have heard me talk about collars in this blog before and if you are an investor and have still not considered using them, why not? Like everything about options there are risk/reward tradeoffs. Selling a call limits the upside of the stock and I get it. But without a long put to cover your position, the damage done could be far worse than taking a smaller gain in the underlying.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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