A collar is an advanced options strategy where investors sell call options and buy put options on stock they own to limit their potential losses from those shares. But a collar also limits any potential gains from those shares.
This article will discuss how collars work, how to implement them, and when they can play a valuable role in an investor’s portfolio.
Definition and Examples of a Collar
A collar involves owning shares and using a combination of call and put options to limit the risk of loss on those shares in the short-term at the cost of limiting any potential gains as well.
In effect, you pass up on profits from large price increases in exchange for avoiding losses from large drops in value. To do this, you must see a call option and buy a put option for the stock you want to place a collar on.
Call options give the holder the right, but not the obligation, to buy shares at the predetermined strike price. Put options give the holder the right, but not the obligation, to sell shares at the predetermined strike price.
For example, if you own 100 shares of XYZ, which currently trades at $100 per share, you may choose to set up a collar. To do this, you could sell a call option with a strike price of $110 and buy a put option with a strike price of $90, both with the same expiration date.
When the expiration date comes, if the price of XYZ is between $90 and $110, both options will expire without worth and you’ll make or lose money based on the prices of the options you bought and sold.
If the price is below $90, you can exercise the put, selling your shares for $90 each. Your loss is limited to the amount you paid for the put minus the amount you earned from the call plus the $10 per share loss.
If the price is above $110, the option holder will likely exercise the option, buying your shares for $110. Your profit will be limited to the amount you earned from selling the call minus what you paid for the put plus the $10 per share gain.
- Alternate name: Protective Collar
How Do Collars Work?
Collars work by setting minimum and maximum prices at which point you can sell the shares that you own. The call option creates a limit to how much the shares can gain value before the option holder exercises the call and buys your shares. At the same time, the put option gives you the option to sell your shares at a minimum price, even if their market value falls below that amount.
Buying a put option, which limits your potential losses without limiting gains, is a popular option for limiting risk. However, buying puts costs money on a regular basis. Selling calls alongside these puts lets you recoup some or all of the cost of buying the puts in exchange for limiting upside potential.
Like other options strategies, investors typically need to meet certain requirements before buying and selling options, including maintaining certain amounts of equity in their portfolios.
Alternatives to Collars
The most basic alternative to a collar is a protective put. Investors can purchase put options with a strike price below the current market value of the shares that they own. This lets investors limit their potential losses in exchange for the premium paid to buy the put.
Another alternative to collars is to sell covered calls. Investors who wish to do this sell call options with strike prices above the current market value of their shares. This limits potential gains because the option will likely be exercised if the stock price rises above the call’s strike price. However, it also lets investors produce additional income from their portfolios. There is a mild risk-limiting aspect, as well, because investors will retain the premium they received for selling the option even if the shares become worthless.
Finally, investors can simply accept the risk of owning stock and choose not to buy or sell options. In this scenario, losses will be limited to the full amount invested in the stock, but there will be no potential limit on gains.
Pros and Cons of Collars
- Limit losses from dropping stock values
- Less expensive than protective puts
- Limit gains from rising stock values
- Strategies involving options can be complex
- Limit losses from dropping stock values. Buying a put option limits the potential loss on an investment to the amount paid for the put plus the difference between the share’s market value and the strike price minus the premium received from selling the call.
- Less expensive than protective puts. Combining the purchase of protective puts with the sale of calls means that investors can recoup some or all of the cost of buying the puts.
- Limit gains from rising stock values. If the value of the stock rises above the strike price of the call option, the option holder will likely exercise it. This limits your profit to the premium received for selling the option plus the difference between the share’s market value and the strike price minus the price paid to buy the protective put.
- Strategies involving options can be complex. Options can be complicated and involve more complex tax situations than investing solely in stock. You may also need to apply for options trading permission with your brokerage, adding extra steps to the process.
Are Collars Worth It?
Whether collars are worth using depends on your investment strategy and the risk of the underlying stock.
Collars are designed to help investors limit potential losses at the cost of limiting potential gains in volatile markets. This makes them ideal to use when you don’t have a strong forecast for how a company’s stock will perform in the short term.
If you’re in a situation where a significant loss will damage your investment plan and aren’t relying on explosive growth from a position, a collar can be a useful tool for hedging risk. If you’re able to withstand volatility in a stock’s price over the short-to-medium term, then a collar will be less useful.
What Collars Mean for Individual Investors
Collars are one way for advanced individual investors to limit their potential losses on an investment in exchange for limiting their gains. Compared to traditional stock trades, they carry a higher degree of risk than is typically associated with trading options.
There are less complex alternatives that can help you achieve the same outcome of capital protection. You can also adjust your asset allocation to reduce volatility and risk as you near the date when you need to make withdrawals from your investment accounts.
- Collars limit risk in exchange for limiting potential profits
- To implement a collar, you sell a call with a strike price above the stock’s market value and buy a put with a strike price below the stock’s market value.
- Collars cost less to implement than a protective put strategy that achieves the same goal.