For the past couple of weeks, we’ve been mixing it up with our discussion of options. That is, instead of focusing on the usual, simple route of selling puts or covered calls, we’ve been telling readers about options strategies that go a step or two beyond.
Continuing with this thread, there is another strategy that options traders should be aware of: collars.
An options collar takes place when an investor is long stock and wants to protect profits by selling a covered call at a strike price above the current stock price and by buying a put at a strike price below the current strike price.
Although not as widely used as the other strategies we’ve detailed, it can often prove very useful when the situation is right. Let’s dive in and learn more…
How A Collar Works
A collar is an interesting strategy often employed by major investment banks and corporate executives. But individual traders may find it useful, too. This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to make this trade is essentially zero.
Here’s an example of how a collar works…
Let’s say you own a significant amount of XYZ stock currently trading at $100. You feel strongly about XYZ’s prospects over the next three months but are worried about losing a substantial portion of your investment. After careful consideration, you decide that while you can’t afford to lose your entire investment, you still would like to get a little more out of your position.
So you decide that you would like to try to get $10 more per share for the stock, or $110. On the other hand, you determine that you cannot afford to sell your shares for anything less than $90.
To hedge this position, you can implement a collar trade. (This trade gets its name because the position is essentially “collared” between two prices.)
It is currently January, so to collar this position for three months, you sell one XYZ MAR 120 call for every 100 shares you own. With the amount you receive from this sale, you simultaneously buy one XYZ MAR 80 for every 100 shares you own (we assume that both sides cost $5 each).
Since both of these options cost the same price, the net cost of this initial trade was $0 to you. With this trade, you now know that no matter what happens, you will receive an amount between $90 and $110 if you decide to sell your XYZ shares when the options expire in March.
As the graph above shows, your total profit or loss from the combinations of these positions is limited to $10. This means that if XYZ rockets up to $200, the most you will receive is $110. Conversely, if XYZ crashes to $20, the least you will receive is $90.
If you’re comfortable with either of the two scenarios, this is an excellent hedging strategy.
To sum up, a collar can help lower your volatility during an uncertain period and can help you lock in a range of sale prices for a stock you currently own.
Investors who hold a large position in an underlying stock and wish to liquidate their holdings in the future may use this type of trade. That’s because a collar allows you to lock in a particular sale price (it actually ends up being a range between two prices) ahead of time. In other words, after implementing the collar trade, you know the exact highest and lowest dollar amounts you could potentially receive when you sell the underlying stock.
Speculators do not commonly make this type of trade since it is a high-risk, low-reward scenario unless you hold the underlying stock. However, if you own the underlying stock, the trade is very low-risk and low-cost.
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