Simplifying the Collar Option Strategy - [Core Concepts for Every Trader]

When mixing stocks and options, investors have various ways to shield against market swings. The collar option strategy offers a balanced approach that mixes options and a stock position. What is a collar in options? Let’s look at the definition and then move on to a collar strategy example to understand how the collar payoff can protect against losses at the cost of capping your potential gains.

Key takeaways

• A collar option strategy is an options strategy where an investor holds an underlying stock, buys an out-of-the-money put, and sells an out-of-the-money call, effectively capping both gains and losses.
• The collar option strategy is ideal for investors looking to hedge a long position against short-term downside risk while balancing potential outcomes.
• Though it provides protection from losses, the collar strategy can also restrict profitability during strong market uptrends.

What Is a Collar in Options?

So, what is the collar option strategy? It's an approach traders use to balance risk and reward effectively. At its core, an options collar involves three key components: owning the underlying stock, purchasing an out-of-the-money (OTM) put option for protection against downside risk, and selling an OTM call option to generate income. This structure helps mitigate the impact of market volatility.

Collar - Basic Structure

• Underlying Stock: You start by owning shares of a stock. In fact, this trade may just begin as a stock purchase, which you choose to cover with options either at the same time you open it, or at a later stage.
• OTM Put Option: Buy this for downside protection, ensuring you can sell your stock at a predetermined price if the market drops.
• OTM Call Option: Sell this to earn a premium, offsetting some of the put option's cost at the cost of capping the potential profit.

The primary purpose of utilizing a collar strategy is to reduce the volatility impact on your portfolio. It provides a safety net when markets are turbulent, preserving gains you've already made.

When is the Collar a Good Idea?

• When you're looking to protect gains without completely exiting your long position on a stock or an ETF.
• If you want to generate additional income through call premiums.

In any case, it goes without saying that the collar strategy only makes sense when you are bullish on a company and its stocks. For instance, you may buy tech stocks you believe in long-term but want to safeguard against short-term dips in the sector. Thanks to an options collar, you ensure your investment's profit chance while accepting limited upside in exchange for peace of mind. This approach, while conservative, can appeal to investors seeking stability and predictable outcomes.

The Collar Option Strategy Payoff

You now know what a collar is, but how does its profit and loss (P&L) diagram look like? Here is an example of what you'll normally see in terms of collar payoff:The collar option strategy is designed to protect your investment while limiting potential profits. Here's a quick breakdown using hypothetical numbers:

• Entry Details: Suppose you bought a stock for $120. You can sell a $125 call and buy a $115 put. If the entry debit is $2, your cost basis becomes $122.
• Profit Potential: If the stock rises above $125, your maximum profit is capped. In this example, your profit potential would be $300 ($125 - $120 - $2 debit, multiplied by 100 shares).
• Loss Limitation: The collar strategy protects you against any drop below $115. The maximum loss would be limited to $700 ($120 - $115 - $2 debit, multiplied by 100 shares).

A Collar Strategy Example

As always, an example will help you grasp the collar option strategy better. Picture this: you foresee the US stock market rising in the coming months, but recognize potential risks like geopolitical tensions or political elections that could swing the market. To manage these uncertainties, you decide to use an options collar on an ETF, such as SPY. Our options screener may show you this opportunity:

• Buy 100 SPY shares at $562.13
• Buy a $530 put and sell a $549 call, both expiring in 50 days

This is the P&L of your strategy:This setup caps your maximum loss at $1,356 if SPY falls below $530 by expiration. This is calculated as the difference between your purchase price and the put strike price, multiplied by the number of shares. Conversely, your maximum profit is capped at $544 if SPY climbs above $549. This profit is derived from the difference between the call strike price and your purchase price, adjusted for the premium received from the call. The breakeven price for this collar strategy is $543.56. If SPY ends up at this price on expiration, you neither gain nor lose money. Your annualized return, should SPY hit the upper bound, is calculated at 6.82%.

Why Open this Collar Strategy on SPY?

We have already established that you may have your own reasons to be bullish on SPY, but why would you choose to go with a collar strategy instead of any other bullish option strategy? Well, we've already told you about the benefits of the collar option strategy above but, for this specific case, the $543.56 breakeven price conveniently sits on a critical threshold for SPY. If you look at its historical price, SPY clearly has a support/resistance level around $545:We also like the fact that, once your options expire, you may just choose to repeat the same collar strategy. If you're still bullish on SPY, why not? Otherwise, you can just keep the shares and decide to unload them later. The fact that the market tends to go up in the long term tells us that holding onto these shares for a while may not be a bad idea.

Pros and Cons of the Collar Strategy

After a theoretical introduction and an example, it is easier to understand the pros and cons of the collar option strategy. This approach offers a nice blend of benefits and drawbacks that can influence an investor's decision to use it. In fact, here is a table that summarizes the pros and cons of the collar strategy:

Advantages of the Collar Strategy

1. Limits Downside Risk: One of the primary benefits of the collar strategy is its ability to cap potential losses. By purchasing a put option, investors protect themselves from significant downturns in the market.
2. Generates Income: Selling a call option as part of the options collar not only helps offset the cost of the put but also brings in extra income (in fact, the collar strategy usually generates a credit, even though you could technically choose a setup that won’t give any credit). This income can be particularly useful in turbulent market conditions.
3. Cost-Effective Protection: Compared to other hedging strategies, the collar strategy can be relatively inexpensive. The income from the call option can sometimes cover the cost of the put, creating what's known as a zero-cost collar.

Disadvantages of the Collar Strategy

1. Capped Upside Potential: A significant downside is the limitation on profit. If the underlying asset's price skyrockets, the investor’s gains are capped at the strike price of the call option. If you are interested in other profit-cap strategies, you can check out our bear put spread strategy article.
2. Complexity in Selection: Choosing the appropriate strike prices and expiration dates for the options can be complex. It requires a good understanding of the market and the underlying asset's behavior.
3. You Should Only Apply Collar on an Underlying on Which You Are Bullish: If you are not comfortable holding onto the underlying stock (or ETF, as you saw in our SPY example) for a long time, or if you believe it will decline in value, then using a collar strategy is not appropriate.

When to Use a Collar Strategy (and When to Avoid It)

As you may have guessed after the theory and the practical example above, you will normally choose a collar strategy when these conditions hold:

• High Volatility or Decline Risk: The collar option strategy is typically used when investors anticipate increased volatility or a potential drop in their asset’s value but do not want to sell their holdings.
• Long-Term Holding: This strategy is particularly useful for investors who wish to hold onto their stock for long-term growth while protecting against short-term market fluctuations. If you don't intend to hold the stock, other strategies may be more appropriate.

Instead, you'll want to avoid the collar strategy in some situations, such as:

• Not Ready to Hold the Stock for Long: Ask yourself whether you are ready to hold the position in the stock for the long term. If the answer is “no,” then the collar strategy is probably not the way to go.
• Strong Bullish Trends: If the market is on a strong upward trend, the ceiling imposed by the call option could mean missing out on substantial gains.

And if you expect the stock to move well outside a range facing high volatility, a trade like the reverse iron condor strategy may be ideal. By weighing these factors, traders can make informed decisions about whether the collar option strategy fits their investment goals. While it offers protection and potential income, the restricted upside and complexity in execution must be considered. The collar strategy example illustrated earlier shows how this approach can be tailored to specific market conditions, offering a balanced way to manage both risk and reward.