Learn how a collar strategy—a covered call and a protective put—might be a cost-effective way to limit risk.
Suppose you’re long a stock that has appreciated nicely, but you’re getting nervous that it may move lower. You don’t really want to exit the stock, but you’re not sure how to protect your investment.
Or suppose you’re thinking about buying a rallying stock that looks like it still has some upside, but you want some measure of protection in case the party ends abruptly.
What do these scenarios have in common? They could both use an option strategy called a collar to help reduce risk while accepting that we now have a limited upside. A collar has three components: a long stock position, a short out-of-the-money (OTM) call option, and a long out-of-the-money put option.
For those with no existing stock position, the collar can be traded as a package. It’s a covered call with a protective put, which means purchasing stock, selling a call on the stock, and buying a put to define the overall risk.
If you already have a long stock position, the collar is created by buying an out-of-the-money put and selling an out-of-the-money call around the current stock price in the same expiration cycle. The choice of strikes determines the potential risk and reward of the combined position (long stock, long OTM put, and short OTM call).
Don’t forget the multiplier. Standard options contracts control 100 shares of stock, so you multiply by 100 to compute their actual cash value. For example, if an options contract is $1.50, your cash outlay is $150, plus transaction costs.
Events such as quarterly earnings announcements can be nerve-wracking for shareholders. If the company reports poor results, the stock may move lower, and without any protection, your investment will suffer. So you might consider putting on a collar, choosing strike prices for the put and call that match your risk profile.
What does that mean? The trade-off is between premium and strike price. Buying a put closer to the money will potentially give you more protection, but it will be more expensive to purchase than a strike further out of the money. The same holds true for the call you sell—if it’s just OTM you’ll get a higher premium, but a greater likelihood of assignment.
In other words, choosing strike prices means finding the right balance of reducing risk while allowing room for potential profit.
Let’s say you’ve been looking at buying 100 shares of XYZ stock for $50 (or a net of $5,000, minus transaction costs), but you want to limit your loss to a fixed amount, say $500. You’re willing to cap your gains at $500 through the expiration date of June 16. To construct this position, you could buy 100 shares of XYZ stock for $50, buy a 16 Jun 45 put for $0.50, and sell one 16 Jun 55 call for $0.50. This would leave you long 100 shares of XYZ stock for $50, and with the 16 Jun 45/55 collar for no cost (plus any transaction costs). This is often referred to as a “zero-cost collar,” because the put purchase and the call sale were executed for a net outlay of zero (plus transaction costs).
FIGURE 1: ZERO-COST COLLAR PAYOUT GRAPH.
Losses are capped at the long put strike; gains are capped at the short call strike. Source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The net result is a position with a maximum loss of $500 if the stock is below $45 at expiration, and a maximum gain of $500 if it’s above $55 at expiration. If XYZ closes below $45 at expiration, you would exercise the put, essentially selling your long stock at $45. If the stock closes above $55 at expiration, you’ll be assigned the short call, essentially selling your long stock at $55.
And if XYZ is anywhere between $45 and $55 at expiration, the 45 put and the 55 call would be out of the money and expire worthless, leaving the long stock position in place—with no protection. If expiration is approaching and it looks like this may happen, you might consider rolling the options out to a later expiration to keep your protection in place. Of course if you have passed the event that caused the concern, then getting past that event, and still having the stock at about where it was, is the whole idea.
** Profit and loss figures are hypothetical and do not include transaction costs. **
This is just a brief overview of the collar. If you’re looking to protect an existing long stock position, or want to enter a new stock position but limit your risk, then a collar might be just what you have been looking for. Hold the starch.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
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Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
The collar position involves the risks of both covered calls and protective puts. The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. With the protective put strategy, while the long put provides some temporary protection from a decline in the price of the corresponding stock, this does involve risking the entire cost of the put position. Should the long put position expire worthless, the entire cost of the put position would be lost.
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