Introduction
A collar strategy involves ownership of the underlying security and the buying of protective put options and the selling of call options. The put options and the call options are out of the money option contracts.
If the collar strategy sounds familiar to you, you are right about that. The collar strategy is technically equivalent to a covered call with a protective put. So the collar strategy is a modification of the covered call strategy.
A Net Debit
The collar strategy in this example results in a net debit.
Collar vs covered call
In a collar the downside is limited as the trader has purchased a put option. However, in a covered call, the downside or loss is unlimited if the underlying security decreases. So in a collar, the advantage is that losses are limited when there are sharp unexpected declines in the underlying security price. In both the collar and the covered call, the trader gets to keep the premium of the shorted call.
Steps
Step 1 : Perform Economic, Fundamental & Technical Analysis
Step 2 : Outlook : Mildly Bullish
Step 3 : Examine The Option Chain
Step 4 : Perform Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Understand That A Loss Is Capped In A Collar Strategy
Step 7 : Loss calculation
Step 8 : Limited potential profit
Step 9 : Calculate The Maximum Profit of a collar
Step 10 : Calculate Your Risk Reward Ratio
Step 11 : Setting up a collar
Step 12 : Exit The Trade
Step 13 : Record The Trade In A Diary
Step 1 : Perform Economic, Fundamental & Technical Analysis
Firstly, an options trader should perform economic, fundamental and technical analysis to have a sense of the direction of the markets. With a simple screener, the trader is able to find potential candidates for collars. There must be some prospect of an increase in the price of the underlying security.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook : Mildly Bullish
At this point, the trader should be convinced that the the price of the underlying security is able to increase to a small degree.
Step 3 : Examine The Option Chain
The option chain of the underlying security should be examined. At this point, select the strike prices and option contracts to create your collar. The put is at a lower strike price than the call.
Read : Learn to read and understand options chain
Step 4 : Perform Breakeven Analysis
The collar is marked by 1 breakeven point in this example. It is calculated as follows.
Breakeven price point = Acquired price of underlying security + Net Debit
Step 5 : Understand Your Profit Zones
Once you have calculated your breakeven point, You will know what your profit zone is. The price of the underlying security must trade above the breakeven point to be profitable.
Step 6 : Understand That A Loss Is Capped In A Collar Strategy
The losses of a collar are limited because the put option that is bought serves as a hedge against declines in the price of the underlying security. The maximum loss of a collar occurs when the price of the underlying security is less than the strike(exercise) price of the put option that was bought.
Step 7 : Loss calculation
Maximum loss of a collar = Commissions paid to broker + Acquired price of underlying security – Exercise price of long put – Net premiums received
Step 8 : Limited potential profit
When the price of the underlying security trades above the strike(exercise) price of the written call, both the call option and the put option expire worthless. When that happens, the trader earns a limited profit.
Step 9 : Calculate The Maximum Profit of a collar
Maximum profit of a collar
= Exercise price of the short call – acquired price of underlying security – Net premiums received – commissions paid to brokers
Step 10 : Calculate Your Risk Reward Ratio
Calculate the risk reward ratio for this trade. Is the risk reward ratio attractive. Is it comparable with the other collar trades you have done in the past?
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Setting up a collar
- Own 100 shares of the underlying security
- Buy 1 out of the money put options contract
- Sell 1 out of the money call options contract
Step 12 : Exit The Trade
The trader can liquidate the collar if he feels satisfied with the profit gained thus far. Profit is limited in a collar. He must also be ready to be assigned if and when the call is assigned.
Step 13 : Record The Trade In A Diary
After the trade has been offset, the trader can calculate the amount earned or lost in his diary and review the entire trade process. If there are mistakes, the trader should learn from them. A trader should also try to make a concerted effort to improve risk reward ratio and profitability in a collar.
Example
FBT Corp is trading at a price of $53 today. A hedge fund manager wants to buy 100 shares and pays $5300 for those shares. He also wishes to collect premium by writing an out of the money December 55 call and buy a December 50 put. The premium received from the call options was $200 and the premium paid for the put option was $100. The net premium received is calculated as : $200 – $100 = $100
The total invested amount by the hedge fund manager is thus:
$5300 – $100 = $5200
On the expiry date of the options, the trading price of FBT Corp became $57. The call option which was shorted became assigned and the hedge fund manager was forced to sell his 100 shares at a price of $55. Hence, the profit from this trade is:
$5500 – $5200 = $300
As you can see, the profit is limited because of the shorted call that the hedge fund manager owns forces him to sell his shares at $5500.
If the price of FBT stayed constant at $53, the options would have expired worthless and the hedge fund manager gets to keep $100 of net premiums
If the price of FBT drops below $49, the hedge fund manager would lose $200 as his protective put option allows him to sell 100 shares at $5000 because the strike(exercise) price of his put option is $50.
Loss = $5200 – $5000 = $200
Costless collar
A variation to the collar strategy is the costless collar strategy. A trader that executes the costless collar strategy places more emphasis on capital protection that the collection of premium from the shorted call option. The costless collar is a bullish strategy that is a variation and an alternative to the traditional collar strategy.
Read next: Execute A Costless Collar To Limit Downside