WHAT IS COLLAR STRATEGIES?

 

The collar strategy: a comprehensive guide

 

   A collar strategy is a popular options trading strategy designed to protect an investor’s profits or limit losses on an existing position. It is a risk management strategy typically used after a stock has experienced significant gains and the investor wants to protect those gains while still allowing for some potential upside. The strategy involves holding a stock (or a similar long position) while simultaneously using options to create a "collar" around the stock's price movement, which limits both downside risk and upside potential.

 

   In this article, we will explore the mechanics of a collar strategy, its components, the rationale behind using it, potential advantages and disadvantages, and examples to understand its practical use.

 

Components of a collar strategy

 

The collar strategy involves three key components:

 

Owning the underlying stock:

 

   The first step of a collar strategy is owning or buying the underlying stock. This strategy is usually applied by investors who already hold a stock position that has appreciated in value. This stock serves as the foundation of the strategy.

 

Buying a put option:

 

   A put option gives the investor the right, but not the obligation, to sell the stock at a specific price (called the strike price) before a certain date (the expiration date). This protects the investor from significant losses if the stock's price falls. The strike price of the put is usually set at or slightly below the current market price of the stock. This limits the downside risk of the stock.

 

Selling a call option:

   A call option gives the buyer the right, but not the obligation, to buy the stock at a specific price (strike price) before the expiration date. By selling a call option, the investor agrees to sell the stock if it rises above a certain price. This generates premium income, which can offset the cost of the protective put. The strike price of the call option is usually set above the current market price of the stock.

 

   In essence, the collar strategy involves purchasing a protective put and simultaneously writing a covered call on the same underlying asset.

 

How the collar strategy works

 

Let’s break down the process with an example to illustrate how a collar strategy works in practice.

 

Example:

 

Suppose you own 100 shares of XYZ Corp, currently trading at $50 per share. You are concerned about the stock's potential downside but still want to participate in some upside. Here's how you can set up a collar strategy:

 

Own the stock:

 

You hold 100 shares of XYZ, worth Rs.5,000 in total (100 shares * Rs.50/share).

 

Buy a protective put:

 

   You buy a Rs.45 put option that expires in three months. This put option gives you the right to sell your 100 shares of XYZ at Rs.45, regardless of how low the stock price may go. Let’s assume the put option costs Rs.1 per share (or Rs.100 total).

 

Sell a covered call:

 

You sell a Rs.55 call option that expires in three months. The buyer of this call option will have the right to purchase your 100 shares of XYZ at Rs.55. You collect a premium of Rs.1 per share (or Rs.100 total) for selling this call option.

 

Now, you’ve established a collar with the following characteristics:

 

Stock ownership:  100 shares of XYZ (worth Rs.5,000).

Downside protection:  You can sell the shares at Rs.45 due to the protective put.

Upside limit:  If XYZ rises above Rs.55, you will have to sell the shares at Rs.55 due to the covered call.

 

Risk and reward analysis

 

The collar strategy limits both potential profits and losses. Let’s examine how the strategy performs under different stock price scenarios:

 

1. Stock Price Falls Below Rs.45:

If XYZ’s price drops to Rs.40, you are protected because of the put option. You can sell your shares at the Rs.45 strike price, limiting your loss. Instead of losing Rs.1,000 (if you didn’t have the put), your loss is only Rs.500 (Rs.5 per share) plus the cost of the collar (discussed below).

 

2. Stock Price Between Rs.45 and Rs.55:

If XYZ’s price stays between Rs.45 and Rs.55, nothing happens. The options expire worthless, and you retain ownership of your shares. You are free to continue holding the stock or exit the position.

 

3. Stock Price Rises Above Rs.55:

If XYZ’s price rises to Rs.60, you must sell your shares at the Rs.55 strike price of the call option. While you miss out on additional gains, you have still locked in a profit of Rs.5 per share (from Rs.50 to Rs.55), which equals a Rs.500 gain.

 

Net cost (Premium Calculation):

The cost of buying the put is Rs.1 per share, and the premium you received from selling the call is also Rs.1 per share. In this case, the net cost of the collar strategy is zero. However, in some situations, the cost of the protective put might exceed the premium received from the call, leading to a small debit.

 

Why Use the Collar Strategy?

 

The collar strategy is primarily used to manage risk while keeping the potential for upside. Here are some reasons why investors choose to use a collar:

 

Risk management:

 

  The collar strategy is a hedging tool. It offers downside protection by using a put option, which limits potential losses. This is particularly useful for investors who want to protect their gains after a stock has appreciated significantly.

 

Cost efficiency:

 

   The cost of buying the protective put is offset by selling the call option, making it a relatively inexpensive way to protect a position compared to purchasing a stand-alone put option.

 

Limited profit but guaranteed gains:

 

   If the stock rises, the collar limits your profit. However, this strategy still allows you to capture a reasonable upside, and profits are locked in once the stock reaches the call option’s strike price.

 

Psychological comfort:

 

   Knowing that you are protected against large losses can help investors stick to their long-term strategy and avoid panic selling during volatile market conditions.

 

Disadvantages of the collar strategy

 

Despite its benefits, the collar strategy has some downsides:

 

Limited upside:

 

   The collar strategy caps the investor’s upside potential because of the short call option. If the stock’s price rises sharply, the investor misses out on further gains above the call strike price.

 

Opportunity Cost:

 

   By selling a call option, the investor is giving up the opportunity to profit from significant price increases. This can be frustrating if the stock price rises substantially.

 

Transaction costs:

 

   While the premium from the call often offsets the cost of the put, transaction costs (such as commissions) can eat into profits, especially for smaller trades.

 

Complexity:

 

   The collar strategy involves managing multiple options positions in addition to owning the stock. This can be complex for novice investors and requires careful monitoring.

 

When to use a collar strategy

 

A collar strategy is best suited for the following situations:

 

After significant gains:  When a stock has experienced significant gains and you want to lock in those gains while still maintaining some upside.

During uncertain market conditions:  If market volatility is high and there is uncertainty about future price movements, the collar strategy provides a balanced approach.

For long-term investors:  Investors who want to protect their portfolio but don’t want to sell their stocks may use a collar to hedge against short-term downside risks.

 

Conclusion

 

   The collar strategy is a flexible and effective risk management tool, especially for investors who want to limit their downside risk while retaining some upside potential. By combining a protective put and a covered call, this strategy creates a "collar" around the stock’s price, effectively limiting both the potential loss and the potential profit. Although the strategy can reduce the maximum upside, it provides peace of mind during market volatility and protects gains already realized.

 

   Investors should consider using the collar strategy when they have experienced significant gains in a stock and want to hedge against a potential downturn without completely exiting their position.