Collar Options Strategy Explained: How it Works, Examples

The collar options strategy is an advanced options strategy used by investors and traders to manage risk - often in concentrated stock positions. This strategy involves owning the underlying stock, buying a put option for downside protection, and selling a call option to offset the cost of the put. The simultaneous use of these options creates a protective "collar" around the long stock position, ensuring that losses do not exceed a certain level, and that gains, while limited, are still achievable up to a predefined limit.

To deploy a collar, the holder of a long stock position layers in two different options positions in the same underlying: a long put and a short call. The long put position serves as protection, providing the investor with the right to sell their stock at a predetermined strike price in the event of a sharp correction in the underlying shares. 

Conversely, the short call is usually deployed with an out-of-the-money (OTM) strike price, meaning the strike price is higher than the current price of the underlying stock. The premium received from the short call is used to help offset the cost of the downside put, but it may also limit upside gains in the core, long stock position - much like a regular covered call. 

Together, the combined options positions effectively bracket the stock price, reducing exposure to volatility, and locking in a range of potential outcomes. Ideally, the put and call options will have the same expiration date, so that the protection period of the combined collar is synchronized. 

Constructing a collar option strategy involves three main steps, each tailored to manage the preferred risk-reward profile of the combined stock and options position. Additional details on the construction of a collar options strategy are highlighted below:

• Own the Underlying Stock: Before you can establish a collar, you need to own the underlying stock that you want to manage/protect. In many cases, this will be represented by a legacy position in the portfolio. For example, a collar might be utilized if an investor/trader is concerned about a potential correction in the price of the stock. A collar is usually incorporated when the investor/trader wants to maintain ownership of the core stock position, but envisions some near-term volatility. To establish a pure collar where downside risk flattens out below the put strike and profit potential capped above the call strike, you need to own 100 shares of stock for every collar contract deployed.

• Buy a Put Option: Buy a put option for the same stock. The put option should have a strike price below the current market price of the stock, effectively setting a floor of intrinsic value risk if the market were to correct. The expiration date of the put option should reflect one’s outlook for the stock, as well as prevailing market conditions. Overall, the put position represents protection against a potential drop in the underlying stock's price.

• Sell a Call Option: Sell a call option on the same stock in the same expiration period as the long put. The strike price of the call option will generally be set above the current market price of the stock, representing a cap on the upside profit potential of the shares. Importantly, the premium received from selling the call option usually helps offset the cost of buying the put. Ideally, the cost of the long put is equivalent or slightly lower than the collection in the short call, creating a costless collar where both options can expire worthless and the trader/investor would not take on any additional monetary risk on top of their shares.

The overall effect of the collar strategy is to create a range of more predictable investment outcomes which are effectively bounded by the strikes of the put and call positions. If the stock price drops, the put option provides a safety net that helps limit the losses in the core stock position. On the other hand, iIf the stock price rises, the profits will effectively be capped by the short call, much like a covered call position. 

Importantly, the collar option strategy doesn’t necessarily have to cover the entire stock holding; it can be applied partially to the stock position. This flexibility allows investors to hedge only a portion of their shares, while leaving the rest open to unlimited upside potential. But in that case, the “uncovered” shares won’t be protected in the event of a correction. 

The maximum profit and loss of a collar strategy depend on the strike prices of the options used and the premiums involved.

For example, the strike price of the put option determines the minimum selling price of the stock, thus setting the floor for potential losses. If the stock price drops below this level, the put option can be exercised or closed with the shares, allowing the investor/trader to sell the stock at this strike price, thus capping the downside risk.

Along those lines, the strike price of the call option sets the maximum selling price of the stock, capping some of the upside potential. If the stock price rises above this strike, the profit potential on the shares of stock would be capped at the strike price regardless of how high the stock price goes.

When it comes to the two options positions, the premium received from selling the call option can help offset the cost of buying the put option. Depending on the relative cost of these premiums, this may result in a wash (the premiums are the same), or a net debit/credit. These considerations ultimately affect the risk-reward profile of the combined position, as well as the maximum potential for profit and loss. If the collar is executed for a debit of $0.25 for example, if both options expire worthless and the stock trades between the two options, the trader would lose $0.25.

The maximum profit of a collar strategy is realized if the underlying stock price rises to or above the strike price of the call option at expiration. The profit is the difference between the stock price at the initiation of the collar and the call strike price, plus any net credit from the option premiums (or minus any net cost). This assumes that the entire stock position was covered by the collar (one collar contract for every 100 shares of stock).

The maximum loss occurs if the underlying stock price falls to or below the strike price of the put option. The loss would be the difference between the stock price at the initiation of the collar and the put strike price, adjusted for the net premium. Once again, this assumes that the entire stock position was covered by the collar. 

In order to reinforce the risk-reward profile of the collar strategy, it’s helpful to review several examples. These examples are outlined below. 

Example 1

Situation: Imagine an investor owns 100 shares of stock XYZ currently priced at $50.

Trade Deployment: In order to supplement the long stock position with the collar strategy, the investor makes the following trades, which match his/her outlook for the stock and the prevailing market conditions: 

• The investor buys 1 front month put option with a strike price of $45 for a premium of $2 per share ($200 for 100 shares).

• The investor sells 1 front month call option with a strike price of $55 for a premium of $2 per share ($200 for 100 shares).

Maximum Profit: If the stock price rises to $55 or higher, the position’s value would reach its limit. The profit is the difference between $55 (call strike) and $50 (initial stock price), which is $5 per share, multiplied by 100 shares, totaling $500. Since the premiums are a wash ($200 received and $200 paid), the maximum profit remains $500.

Maximum Loss: If the stock price falls to $45 or lower, the put option protects the risk in the shares. The loss is the difference between $50 (initial stock price) and $45 (put strike), which is $5 per share, multiplied by 100 shares, totaling $500. Adjusting for the premium wash, the maximum loss is also $500.

Example 2

Now let’s examine the value of the collar using two additional scenarios. In this case, imagine the investor/trader has foregone the collar, and instead sticks with the naked long stock position. 

Scenario 1: Stock Price Rises to $60

Without a collar strategy in place:

• Stock Performance: If the stock price rises to $60 per share, the investor benefits from the full price increase.

• Profit Calculation: The initial stock price was $50 per share. With the stock price increasing to $60 per share, the gain is $10 per share.

• Total Profit: Owning 100 shares, the total profit would be: 100 shares × $10 per share = $1,000

Primary takeaways: This scenario illustrates a significant advantage in not having a collar if the stock price rises substantially, because the investor enjoys the full upside potential without any cap imposed by the short call option. However, the investor doesn’t enjoy the protection afforded by the downside put. 

Scenario 2: Stock Price Drops to $40

Without a collar strategy in place:

• Stock Performance: If the stock price drops to $40 per share, the investor will suffer a significant loss in the value of the stock position. 

• Loss Calculation: The initial stock price was $50 per share. With the stock price dropping to $40 per share, the loss is $10 per share.

• Total Loss: Owning 100 shares, the total loss would be: 100 shares × $10 per share = $1,000

Primary takeaways: In this scenario, the absence of a collar means the investor bears the full brunt of the stock's decline, highlighting the value of the protection afforded by the collar strategy. These examples help illustrate why an investor’s outlook on the stock, and the broader market environment, are so integral to the decision-making process. 

The collar option strategy is a valuable risk management tool, particularly suited for investors who wish to manage/protect a core stock holding. Notably, collars are often utilized by investors/traders that don’t want to sell the core stock position outright, but seek added protection for their position during a set period. 

Listed below are some of the other pros and cons that investors and traders can consider when evaluating the collar options strategy. 

Pros of the Collar Strategy

• Downside Protection: One of the most significant advantages of a collar strategy is the protection it offers against substantial declines in the stock price. The put option sets a floor, ensuring that the investor can sell the stock at a predetermined minimum price, regardless of how low the market price may drop.

• Cost Efficiency: The cost of buying a put option for protection on 100 shares of stock is offset by the premium received from selling the call option. This can make the collar strategy more affordable compared to buying a put option outright. 

• Flexibility: Investors can customize the strike prices of the put and call options based on their risk tolerance and market outlook. This allows for a tailored risk management approach that can be adapted to different investment goals and scenarios.

• Maintaining Stock Ownership: The strategy allows investors to maintain an existing stock position, which may be beneficial due to one’s long-term outlook, or for other reasons such as taxes and dividends. 

Cons of the Collar Strategy

• Capped Upside Potential: While a collar provides downside protection, it also limits the upside potential of the combined position. The short call position caps the maximum price at which the investor can sell the stock, potentially creating missed opportunities during a strong market rally.

• Complexity and Management: Implementing and managing a collar strategy can be complex compared to straightforward stock ownership. It requires an understanding of the options market, and may necessitate active monitoring and adjustments.

• Costs of Mispricing: If the premiums of the put and call options don't perfectly offset each other, there might be a net cost to establishing the collar if the put is more expensive than the call. This can add monetary risk for the investor if the stock stays between the put and call strikes through expiration. Additionally, misjudging the volatility and movement of the stock could lead to suboptimal strike price selections, reducing the effectiveness of the overall strategy. 

• Opportunity Cost: A collar options strategy can limit the potential upside of stock position, which may ultimately represent an opportunity cost. This is especially pertinent if the underlying stock experiences a sharp rally during the life of the collar. 

A “collar” options strategy is represented by a combined stock and options position. Specifically, a collar integrates a core long stock position with two strategic options positions. In this regard, the collar is often thought of as a risk management strategy.

To deploy a collar, the holder of a long stock position layers in two different options positions in the same underlying: a long put and a short call. The long put position serves as protection, providing the investor with the right to sell their stock at a predetermined strike price in the event of a sharp correction in the underlying shares. 

The short call is typically deployed using an out-of-the-money (OTM) strike price, meaning the strike price is higher than the current price of the stock. The premium received from the short call is typically used to help offset the cost of the downside put, but it may also limit upside gains in the long stock position - much like a regular covered call. 

One of the primary advantages of the collar strategy is the associated downside protection. This is especially valuable in volatile or uncertain market conditions, where the risk of a significant decline in the underlying stock price may be elevated. The put option component of the collar ensures that the investor can sell the stock at a minimum price, regardless of how low the market price may fall, effectively setting a floor on potential losses.

On the other hand, the collar strategy also involves certain trade-offs, most notably the limitation on the upside potential of the stock. By selling a call option, the investor receives a premium that helps pay for the put option, but in exchange, the investor/trader effectively agrees to sell the stock if its price exceeds the strike price of the call. As such, the collar provides security against potential losses, but it also requires that the investor forgo some potential gains if the stock price rises significantly.

Ideally, the premium received from the call option will offset the cost of buying the put option, potentially making this a cost-neutral approach. This aspect of the strategy can make the collar relatively more attractive, especially as compared to purchasing the put options on their own - the latter representing a more expensive way to protect against a potential correction in the underlying shares. 

Taken all together, the collar options strategy offers a structured approach to managing investment risks by protecting against significant losses, while allowing for moderate upside gains. Remember, for the collar to offer full protection to the downside, a one contract collar strategy must be paired with 100 shares of stock. The key to this strategy lies in selecting appropriate strike prices for the options, and managing the trade-offs between protecting against downside risks versus capping upside potential. Investors and traders must therefore carefully assess their market outlook and risk tolerance when implementing the collar strategy to ensure it aligns with their broader outlook and goals.