Options Collars: A Strategy for Straying Stocks

The following, like all our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors. Collars and other multiple-leg options strategies can entail substantial transaction costs, which may impact any potential return. 

Hedging a stock with a long put is a common strategy for many investors, but it can often be too expensive and cut into their overall returns. One way some investors reduce the cost of the hedge is by selling a call option at the same time to help offset some, if not all, cost of the put. This strategy is called a collar. However, there are different ways to approach a collar. Let’s discuss a few.

There are three components of a collar: long stock, a short out-of-the-money (OTM) call, and a long OTM put—the call and put have the same expiration (see figure 1). Selling the call with a strike above the stock price and buying a put below the stock price creates the collar.

Because a collar is a short-term hedge, it’s not designed to be particularly profitable. Instead, it’s used to potentially reduce losses if the stock price falls. With that said, a profit may be realized if the stock price moves higher, but not too high. You see, the short call caps any potential profit of the long stock at the short call’s strike price. Remember, when you sell a call, you are obligated to deliver the stock to someone else at that strike price at or before expiration. Also, the value of the put decreases as the stock price increases.

A loss can occur if the stock price starts to fall. The maximum loss can be realized if the stock’s price falls below the put’s strike price at expiration. While no one likes to take a loss, if the stock does fall below the put’s strike price, it means your hedge is working because you’re mitigating the losses on the stock.

Delta is more than change

Technically, the collar is a bullish strategy that has positive deltas—meaning it benefits from the long stock moving higher. Positives deltas come from the long stock, which has 100 positive deltas; that’s one delta for each share. Both the long put and short call have negative deltas, but how much depends on the strikes. When the position comes together, it still has more positive deltas than negative deltas.

Let’s flesh this out with an example. Say an investor has a 100 shares of a $50 stock, each share will have a delta of 1. The 52-strike calls have a 0.40 delta, but when they’re sold instead of purchased, those deltas become negative. Finally, the 48-strike puts have a –0.40 delta. Let’s add up the deltas.

100 shares of stock = +100 deltas Short 52 calls = 40 deltas Long 48 puts = 40 deltas

100 + 40 + 40 = +20

So, the collar has positive 20 deltas, which means the investor is bullish but not super bullish. Remember, the long stock has 100 deltas, so with only 20 deltas, the investor isn’t looking for a big positive move.

The deltas will change depending on the strike selection. The further OTM the long put or short call, the fewer negative deltas. Conversely, if the long put and short call strikes are closer to the current stock price, they have more negative deltas, thus reducing the number of positive deltas.

So, if the investor favors a wider collar where the 55-strike calls with a delta of 0.20 and the 45-strike puts with a delta of 0.25, the collar would have +55 deltas (–20 + –25 + 100). That’s why choosing the strikes for the calls and puts determines how bullish you want the strategy to be.  

Don’t choke on a collar

It’s common for traders to place a collar over their long stock and let it go to expiration without adjusting it. If the options expire worthless, then any amount money tied up in the collar would be lost. However, there are other ways to approach a collar. One approach that is more flexible is a “dynamic collar.”

A dynamic collar requires investors to act a little more like traders because it follows the performance of the call and put options individually too. The investors may choose to close these options if they increase in value and use the funds elsewhere. Let me explain.  

Let’s say an investor has 1,000 shares of stock. They’re buying 10 OTM puts as a hedge, then selling 10 OTM calls to help offset the cost of the puts, thus completing the collar. If the stock price drops, the long puts and short calls should theoretically be profitable despite the losses in the stock. This is because the short calls and long puts have negative deltas.

If the investor was confident that the stock wasn’t going to fall further, they could close both the call and put positions and pocket any gains. Then, if the stock rallies, they’d no longer have a cap on the performance of their stock. However, if the investor is wrong and the stock does fall, they could have greater losses.  

If the investor was able to close their calls and puts for a profit, they’ll have more money to work with. If they thought the stock was going to rise, they could buy more shares of the stock. This might make sense for long-term investors who aren’t accustomed to selling stocks.

In fact, let’s suppose this investor had enough to buy 100 more shares. That would give them 1,100 shares. If they felt the need to keep the collar going, they’d need to buy 11 new OTM puts and sell 11 new OTM calls. Of course, the larger position could create more positive deltas, which means the investor has the potential for greater gains but also more losses.  

Hedging with long puts is one way investors can try and mitigate potential losses, and a collar provides a way to make hedging less expensive. Dynamic investors who are able to close their collars for a profit can use those funds to add to their stock position. In the end, at some point, the stock needs to start climbing again to make the entire strategy worthwhile.