The Collar Strategy Explained

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What is a Collar Strategy?

A collar is similar to Covered Call but involves another leg—buying a Put to insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a Collar is buying a stock, insuring against the downside by buying a Put and then financing (partly) the Put by selling a Call.

The put generally is ATM and the call is OTM having the same expiration month and must be equal in number of shares. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservatively bullish. The following example should make Collar easier to understand.

When to use: The collar is a good strategy to use if the investor is writing covers calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security.

Breakeven: Purchase Price of Underlying—Call Premium + Put Premium

Example

  1. If the price of ABC Ltd. rises to Rs. 5100 after a month, then,
  • Mr. A will sell the stock at Rs. 5100 earning him a profit of Rs. 342 (Rs. 5100—Rs. 4758)
  • Mr. A will get exercised on the Call sold and will have to pay Rs. 100.
  • The Put will expire worthless.
  • Net premium received for the Collar is Rs. 12.
  • Adding (a +b+d)= Rs. 342—100—12= Rs. 254

This the maximum return on the Collar Strategy

However, unlike a Covered Call, the downside risk here is also limited:

2) If the price of ABC Ltd. falls to Rs. 4400 after a month, then,

  • Mr. A loses Rs. 358 on the stock ABC Ltd.
  • The Call expires worthless
  • The Put can be exercised by Mr. A and he will earn Rs. 300
  • Net premium received for the Collar is Rs. 12
  • Adding (a+b+d)= —Rs. 358+ 300 +12= —Rs. 46

This is the maximum the investor can loose on the Collar Strategy. The Upside in this case is much more than the downside risk.

Get to know more about online trading strategies in our knowledge base section.

The Collar Strategy Explained

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Collar

B/S Strike Type Price
Buy 100 Shares N/A Stock $50
Buy 1 $49 Put $0.97
Sell 1 $51 Call $1.00
Net Debit $5,003

A Collar is being long the underlying asset while shorting an OTM call and also buying an OTM put with the same expiration date.

The Max Loss is any loss taken on the stock +/- the premium for the options. The loss on the stock will be the purchase price of the stock minus the strike price of the put option (as you will exercise at that price) plus the net premium paid or received.

The Max Gain The profit of the stock +/- the premium for the optoins. The profit on the stock will be the strike price of the call option minus the purchase price of the stock (as you will be exercised and deliver at the strike) plus the net premium paid or received.

Characteristics

As you can see from the above payoff chart, a collar behaves just like a long call spread.

It is suited to investors who already own the stock and are looking to:

  • increase their return by writing call options
  • minimize their downside risk by buying put options

Covered calls are becoming very popular strategy for investors who already own stock. They sell out-of-the-money call options at a price that they are happy to sell the stock at in return for receiving some premium upfront. If the stock doesn’t trade above this level, the investor keeps the premium.

The problem with covered calls is that they have unlimited downside risk.

The solution to this is to protect the downside by buying an out-of-the-money put.

This increases the cost as you will have to outlay more to purchase the put and hence lowers your overall return.

Collar Greeks

Delta

Gamma

Theta

  • Bullish Spreads
  • Long Call
  • Short Put
  • Long Synthetic
  • Call Backspread
  • Call Bull Spread
  • Put Bull Spread
  • Covered Call
  • Protective Put
  • Collar
  • Bearish Spreads
  • Short Call
  • Long Put
  • Short Synthetic
  • Put Backspread
  • Call Bear Spread
  • Put Bear Spread
  • Neutral Spreads
  • Iron Condor
  • Long Straddle
  • Short Straddle
  • Long Strangle
  • Short Strangle
  • Long Guts
  • Short Guts
  • Call Time Spread
  • Put Time Spread
  • Call Ratio Vertical Spread
  • Put Ratio Vertical Spread
  • Long Call Butterfly
  • Short Call Butterfly
  • Long Put Butterfly
  • Short Put Butterfly

Show/Hide Comments (23)

Mc ClaneDecember 30th, 2020 at 2:11pm

My comment might be a little off the subject but I thought this might be the best place to ask. I have millions of penny stocks in about 8 companies (OTCBB & pinksheets)I’ve been holding the stocks for over 7 years now and none of them have had impressive returns therefore wouldn’t like to sell’em.. I have the understanding that OTCBB & pink sheets stocks don’t trade options. My question is what can I do with these? Is there a strategy fit fot these kind of situations? Greetings!

PeterOctober 29th, 2020 at 4:41am

Apologies for the delay in responding!

1) It is risky in the sense that you have no upside or downside protection. But this is no more of risky position than holding the stock outright as your position resembles a synthetic long stock.

2) No, you will “add” to the risk if you “bought” the stock. If you “sold” the stock you would be short a collar.

3) A Long Synthetic.

4) Nothing if you bought, but if you sold the stock it would be a Short Collar.

5) You could look to buy the stock and the sell the call and buy the put for a Long Collar.

ArthurOctober 9th, 2020 at 3:30pm

Hey,
I bought a Nov 2.5 Call and sold a Feb 5 put, both on BSDM (stock closed at 2.02 today). Got a few of questions:
1) Is this an unreasonably risky trade?
2) Can I mitigate the risk by buying the stock at say, $2.08?
3) What strategy is it called without the stock?
4) What strategy is it called if I buy the stock?
5) Is there a better way to have done this?
Thanks for your responses (I just discovered your site today. I would have made a better trade had I found it earlier). Great site!

PeterAugust 13th, 2020 at 7:48pm

If you “must” protect the total $1,000,000 then best not to trade at all – leave the money in the bank and earn interest.

If you wanted to put on a collar you will need to buy some stock first and then also sell call options to offset the purchase of the puts. However, with a collar you will still have some downside risk to consider, which is the maximum loss on the trade if the market sells off.

If you want to buy stocks and are looking for downside protection then you could also look at a Protective Put.

marianAugust 11th, 2020 at 11:06am

Hi Peter,
Suppose I had $1,000,000 and in 1 year I still want to have at least the same amount. If possible, I want to make some profit but I must protect those $1,000,000. Would you recommend a collar option strategy in this case?
Thanks for your help!

PeterApril 25th, 2020 at 10:26pm

Yes, I see that the description above can be a bit confusing. I’ve modified it so it is a little clearer.

In your example above, if the stock is below K1 then your loss will any loss on the stock +/- the premium for the option legs. So, the purchase price of the stock minus the K1 (as you will exercise and sell the stock at that price) plus premium received (or less premium paid).

kamalApril 24th, 2020 at 4:52am

First thanks for this very helpfull website.

I can’t understand when you say that the maximum loss would be : “Limited to the difference between the two strikes less the net premium paid or received less the loss on the stock leg”.

Collar Options Trading Strategy In Python

The current market environment is pretty challenging and there is a need to be clever in the way we invest and look for other opportunities. As a trader, one is always on the lookout for assets that can perform well in the markets and at the same time realise good profits.

Sideways performing strategies provide a good opportunity for a trader to grab hold of. And if the trade is moderately bullish yet cautious on your price, that is when Collar Options Strategy is practised.

This brings up the question,

What Is A Collar?

Stock > Long position > Substantial Gains > Implement Collar

Many often wonder,

What Is the Definition Of A Collar?

Or

What Is The Meaning Of A Collar?

Collar Trading Strategies have a widespread usage. Conservative Investors find it to be a good trade-off to limit profits in return for limited losses and Portfolio managers use it to protect their position in the market, while some investors practise it as it reduces the price of the protective put.

Components Of Collar Trading Strategy Structure

  1. Buy 1 OTM Put option (Put collar) – lower limit – for protection
  2. Sell 1 OTM Call option (Call collar) – upper limit

Both Call and Put options are out of the money, have the same expiry date and their quantity must be equal

Generally, the price will be between two strikes

The strategy would ideally look something like this:

Calculating Breakeven Point

  • Purchase Price – Call Premium (you are short) + Put Premium (you are long)
  • For Net Credit, BEP = Current Stock Price – Net Credit received
  • For Net Debit, BEP = Current Stock Price – Net Debit paid

Limited Profit Potential

  • Max. Profit = Strike Price (of the Call option) – Purchase Price (of the underlying)
  • Max. Loss = Purchase Price (of the underlying) – Strike Price (of the long Put)

Best Rewards: You want the underlying price to expire at the strike price of short call option.

How The Collar Options Strategy Works

Step 1: At Current Price

The market is unstable and the volatility is totally unexpected. When the price of a option rises, there is a probability that the price may fall and you may lose out on the profit. In such a case, the asset needs to be protected.

Step 2: Practise Collar Options

It is under such condition that the Collar Options Strategy is practised. The call that you have sold caps the upside.

What Are The Various Scenarios For Applying A Collar Strategy?

Scenario 1: When Market Is Bullish

Collar option provides limited profits and is used for generating a monthly income from the sideways moving market. This profit can be used as a Collar Payoff against the purchased Put Option. Since the trader owns the option, the call sold is considered “covered”.

Scenario 2: Sharp Bullish Market

If the Price rises suddenly and peaks, then the Calls sold increases in Price leading to a difficulty in selling many securities quickly without moving the market and no profits would be realised.

Scenario 3: When Market Is Bearish

If the Price dips, the Put option is practised. The Price increases in value as the underlying asset moves lower. Here, the sell happens above the Market Value using the Options. Since you have sold the call, if the option is assigned, you’ll have to sell the option at the Strike Price.

Scenario 4: Sidewise Movement

If the Price stays the same until the expiry of the option and since both the options have the same date of expiry, neither are practised and thus they both turn worthless. The maximum loss in such a case would be only the Premium paid for the options as it offsets the Premium paid for the Put Option from the Call Option therefore, minimising the Loss.

Implementing The Collar Trading Strategy

Collar Strategy Example

There has been a lot of movement in the price of IDBI Bank Ltd., the highest being 194.65 and lowest being 117.05 in last 1 month which is the current value as per Google Finance.

For the purpose of this example; I will buy 1 out of the money Put and 1 out of the money Call Options.

Here is the option chain of IDBI Bank Ltd. for the expiry date of 29th March 2020 from the Source: nseindia.com

I will pay INR 3.25 for the call with a strike price of 75 and INR 2.00 for the put with a strike price of 65. The options will expire on 29th March 2020 and to make a profit out of it, there should be a substantial upward movement in the price of IDBI Bank Ltd. before the expiry.

The net premium paid to initiate this trade will be INR 5.25. For this strategy to breakeven, the price needs to move down to 59.75 on the downside or up to 80.25 before this strategy will break even.

How To Calculate The Strategy Payoff In Python?

Define The Parameters

Call Payoff

Put Payoff

Collar Payoff

Summary

Next Step

Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.

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