November 4, 2017

How Does the Collar Option Work?

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What if you could minimize your losses on a stock? It sounds like a dream come true, right? The collar option gives you that chance. It comes at a cost, though. You'd have to maximize your profits. Is it worth it?

It all comes down to your ability to handle risk. If you think a stock you own might plummet, the collar option is a good hedging strategy. It helps you keep your losses to a minimum. But it caps your profits should the stock go in the opposite direction.

Whether or not you should do it depends on you and your financial status.

We'll walk you through the strategy below. Then you can decide if it's right for you.

What Is the Collar Option?

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A collar option helps you hedge against a loss. In order for it to work, you must already own 100 shares of the stock. If you feel bullish, yet are unsure about the stock's future, you can create a collar. In other words, you protect yourself from a huge downturn. In exchange, you maximize your profits. It's a temporary position that's only good as long as the contract is good. If everything expires worthless, you walk away with your stock in your hand.

The collar is really two basic trades put together - the protective put and the covered call. The protective put gives you an exit strategy. If the stock plummets, you have a "floor" set. If the price goes below that floor, you get out unscathed.

The covered call is a short-term profit making strategy. You set the "ceiling" or maximum profit. If the stock goes beyond that price, you sell the stock to the buyer. You benefit not only from the sale, but also from the premium collected for selling the call.

Buying the put and selling the call create a sort of "collar" around the stock. You have a high and low price set. If the stock falls in between those prices, both contracts expire worthless. You may walk away with a slight loss or a slight gain. It depends on the net premium between buying the put and selling the call.

The premium you receive on the covered call helps offset the cost of the protective put. In a perfect world, you make more than you pay. Of course, that doesn't always happen.

It is possible to create a zero-cost collar. If you can buy a put for the same premium that you collect writing a call, you walk away even. If the stock falls within the floor and ceiling, you don't lose or gain anything.

Pricing the Collar Option

Choosing the right strike prices for the collar could be a little trial and error. Typically, you'll sell a call with a higher strike price than the current market price. You'll also buy a put with a lower strike price than the current market price.

Here's an example:

You currently own 100 shares of ABC stock. Today, it trades for $15.

You buy a put with a strike price of $10 for a $3 premium. You sell a call for a strike price of $20 and a $2 premium. Both options have a 3-month expiration.

In order to conduct the trade, you'd pay $300 ($3 x 100 shares) for the protective put. You'd make $200 ($20 x 100) for the written call. You walk away with a total cost of $100.

What if instead, you had the following trade:

You still own 100 shares of ABC stock trading at $15.

This time, you buy a put with a strike price of $12 for a premium of $2. You sell a call for a strike price of $20 and a premium of $2. Both options have the same expiration date of 3 months.

In this case, you'd walk away even. It would cost you $200 to buy the put. You'd make $200 for selling the call. It's an even trade. Now you just wait and see how the stock performs.

Maximum Loss on a Collar

The collar provides you with temporary protection on the stock you own. It's limited for the term of the option, though. Before expiration, your worst-case scenario occurs if the stock's price plummets below the put's strike price.

If this happens, you'd execute the put. In other words, you'd sell the stock you own for the strike price of the put. You minimize your loss because you have a strike price higher than the current market price.

Here's an example:

You own 100 shares of ABC stock, which you bought for $15. Today it still trades at $15 but you worry about the price falling. You buy a put with a strike price of $12. You also sell a call for a strike price of $18. You paid $200 for the put and made $100 for the call. You had a net cost of $100 for the trade.

At the end of the term, ABC's stock plummeted to $10. You exercise your put and sell the stock for $12/share. Your total loss is as follows:

$1,500 (paid $15 x 100 shares) - $1200 (made $12 x 100 shares) - $100 (net premium paid) = $200 total loss

Now let's look at what would have happened if you didn't have the collar (or at least the protective put):

If the stock price fell to $10, you'd likely get nervous and sell to cut your losses. It looks like this:

$1,500 (paid for the stock purchase) - $1,000 (made $10 x 100 shares) = $500 loss

The collar gives you protection to minimize your losses for the duration of the contract.

Your maximum loss = Stock purchase price - strike price of put - net premium paid

Maximum Profit on Collar

In exchange for minimizing your losses, you'll also maximize your gains. This again is limited for the option's term.

The buyer of the call will likely execute the position if the stock's price exceeds the strike price of the call. This requires you to sell the stock at the strike price, rather than the higher market price. This is how your profits are limited.

Here's an example:

You bought ABC stock for $15/share. You bought a protective put with a $10 strike price and a premium of $3. You also sold a covered call with an $18 strike price and a $2 premium. Both contracts expire in 3 months. The trade cost you:

$300 ($3 x 100 paid) - $200 ($2 x $100 made) = $100 net premium paid

If in 3 months, the stock's market price was $20, your call would be assigned. This means you must sell the stock at $18/share rather than $20.

Your profits are as follows:

$1800 ($18 strike price x 100 shares) - $1,500 (original price paid $15 x 100) - $100 (net premium paid) = $200 net profit

Now, if you didn't sell the covered call, you could have sold the shares for the current market price of $20. You would have made:

$2,000 ($20 x 100 shares) - $1,500 (original price paid $15 x 100) = $500 profit

In exchange for the loss protection, though, you maximize your gains.

Your maximum profit = Strike price of call - stock purchase price - net premium paid (+ net premium made)

The Bottom Line

The collar can be a good strategy when you worry about a stock's immediate future. It's also good when you have unrealized gains you'd like to keep. If you aren't ready to let go of the stock yet, the collar helps protect you.

Before you start making simultaneous trades, we recommend starting with basic calls and puts first. Once you get a feel for how they work, you can start trying combinations, such as the collar option.

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