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What Is a Collar?

Sebencapital

Published
19/12/23
What Is a Collar?

Collars Explained

DEFINITION:

A collar strategy in options trading involves investors selling call options and buying put options for stocks they already own. This tactic is used to minimize potential losses from those stocks. However, it also puts a cap on potential gains from those shares.

A collar strategy in options is when investors sell call options and buy put options for stocks they possess. This is done to control the potential losses if the stock price drops. However, it also sets a limit on the possible profits from those shares.

Definition and Examples of a Collar

A collar strategy means you own stocks and use call and put options together to protect against short-term losses. However, it comes at the expense of restricting potential gains. It's like having insurance for your shares, where you sacrifice some profit to prevent big losses.

Essentially, with a collar strategy, you give up making big profits if the stock price skyrockets, but in return, you protect yourself from significant losses if the stock value plummets. To set up a collar, you need to sell a call option and purchase a put option for the stock you're securing.

Note

Call options grant the holder the choice to purchase shares at an agreed-upon price, known as the strike price. Put options give the holder the choice to sell shares at the agreed-upon strike price.

Let's consider owning 100 shares of XYZ, valued at ₹100 each, and wanting to create a collar. To do this, you sell a call option at ₹110 and buy a put option at ₹90, both with the same expiration date.

At the expiration date, if XYZ's price falls between ₹90 and ₹110, both options expire and your gains or losses are determined by the prices you sold and bought the options.

If XYZ's price drops below ₹90, you can use the put option, selling your shares at ₹90 each. Your loss is limited to what you paid for the put minus what you earned from the call, plus the ₹10 per share loss.

If XYZ's price rises above ₹110, the option holder might exercise the call option, purchasing your shares at ₹110 each. Your gain is limited to the amount you earned from selling the call minus the cost of the put, plus the ₹10 per share gain.

  • Alternate name: Protective Collar

How Do Collars Work?

Collars set boundaries for selling owned shares. They use a call option to cap potential gains by giving someone else the right to buy your shares at a certain price. Meanwhile, a put option sets a floor price, allowing you to sell your shares even if their value drops.

Buying a put option is a common way to minimize risks without limiting potential gains. But, it requires regular payments. Pairing this with selling calls helps offset the cost of buying the puts. However, it limits how much profit you can make.

Note

Similar to other options strategies, investors usually have to fulfill specific conditions before trading options, which may involve maintaining specific levels of equity in their investment portfolios.

Alternatives to Collars

A simple alternative to a collar is a protective put. Here's how it works: Investors buy put options with a strike price lower than the current market value of their owned shares. This strategy helps limit potential losses in return for the premium paid to acquire the put option.

Another choice instead of collars is selling covered calls. Here’s how it works: Investors sell call options with strike prices higher than the current market value of their shares. This limits potential gains because if the stock price goes above the call's strike price, the option will likely get exercised. However, it allows investors to generate extra income from their portfolios. There's also a mild risk-limiting aspect because investors keep the premium from selling the option even if the shares lose value.

Alternatively, investors can opt to solely hold the stock without buying or selling options. In this case, potential losses will be restricted to the amount invested in the stock, but there will be no cap on potential gains.

Pros and Cons of Collars

Pros

  • Limit losses from dropping stock values
  • Less expensive than protective puts

Cons

  • Limit gains from rising stock values
  • Strategies involving options can be complex.

Pros Explained

  • Getting a put option can help reduce losses when stock prices fall. It restricts the potential loss on investment to the cost of the put, along with the difference between the market value of the shares and the strike price, minus the premium earned from selling the call.
  • Cheaper than protective puts. When investors buy protective puts and sell calls together, they can recover some or all of the expenses from buying the puts.

Cons Explained

  • Restrict potential gains from increasing stock values. When the stock's value goes beyond the call option's strike price, the holder will probably act on it. This caps your profit at the premium gained from selling the option, along with the difference between the stock’s market value and the strike price, minus the cost of purchasing the protective put.
  • Using options in investing can get intricate. They're more complex compared to just buying stocks and can bring about more challenging tax situations. Additionally, you might have to seek options trading approval from your brokerage, which adds extra steps to your investing process.

Are Collars Worth It?

The decision to use collars depends on your investment approach and the risk associated with the stock you own.

Note

Collars are meant to assist investors in reducing possible losses, but they can also cap potential gains, particularly in uncertain or fluctuating markets. They work well when you're unsure about a company's short-term stock performance.

If you're concerned about a big loss affecting your investment plan and don't expect huge growth from a position, a collar can help manage risk. But if you're okay with short-to-medium term price swings in a stock, a collar might not be as helpful.

What Collars Mean for Individual Investors

Collars are a method for experienced individual investors to control potential losses on an investment but at the expense of limiting their potential gains. They involve more risk compared to regular stock trading or typical options trades.

There are simpler options available that offer similar protection for your money. You can also change how your investments are divided to lower the chance of big ups and downs as you get closer to the time you plan to take money out of your investment accounts.

Key Takeaways

  • Collars reduce risk but also cap potential gains.
  • To set up a collar, you sell a call option with a strike price higher than the stock's current price and buy a put option with a strike price lower than the stock's current price.
  • Using collars is typically cheaper compared to employing a protective put strategy with similar objectives.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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