Trading options collar
Both the put and call are typically out-of-the-money OTM options, and must have the same expiration. The combination of the long put and short call forms a "collar" for the underlying stock that is defined by the strike prices of the put and call options.
The "protective" aspect of this strategy arises from the fact that the put position provides downside protection for the stock until the put expires. Since the basic objective of the collar is to hedge downside risk, it stands to reason that the strike price of the call written should be higher than the strike price of the put purchased. A protective collar is usually implemented when the investor requires downside protection for the short- to medium-term, but at a lower cost. Since buying protective puts can be an expensive proposition, writing OTM calls can defray the cost of the puts quite substantially.
In fact, it is possible to construct protective collars for most stocks that are either "costless" also called "zero-cost collars" or actually generate a net credit for the investor. The main drawback of this strategy is that the investor is giving away upside in the stock in exchange for obtaining downside protection.
The protective collar works like a charm if the stock declines, but not so well if the stock surges ahead and is "called away," as any additional gain above the call strike price will be lost. Protective collars are particularly useful when the broad markets or specific stocks are showing signs of retreating after a sizable advance. They should be used with caution in a strong bull market, as the odds of stocks being called away and thus capping the upside of a specific stock or portfolio may be quite high.
Let's understand how a protective collar can be constructed using a historical example from options on Apple, Inc. You start by writing a covered call on your Apple position. Here's how the strategy would work out in each of the following three scenarios:. Your overall gain would be:. Recall what we said earlier about a collar capping upside in the stock.
If you had not implemented the collar, your gain on the Apple position would have been:. The notional unrealized gain on your Apple holding would then be. A collar can be an effective way to protect the value of your investment at possibly a zero net cost to you.
Safely Make $50,000 Per Year From One Stock? Exploring the Collar Option Strategy
However, it also has some other points that could save you or your heirs tax dollars. For example, what if you own a stock that has risen significantly since you bought it? Maybe you think it has more upside potential, but you're concerned about the rest of the market pulling it down. One choice is to sell the stock and buy it back when the market stabilizes. You might even be able to get it for less than its current market value and pocket a few additional bucks.
Reverse engineering how much capital you need
The problem is, if you sell, you'll have to pay capital gains tax on your profit. By using the collar strategy, you'll be able to hedge against a market downturn without triggering a taxable event. Of course, if you're forced to sell your stock to the call holder or you decide to sell to the put holder, you'll have taxes to pay on the profit. You could possibly help your beneficiaries, too. As long as you don't sell your stock, they'll be able to take advantage of the step-up in basis when they inherit the stock from you. A protective collar can be a good strategy for gaining downside protection in a more cost-effective way than merely buying a protective put.
The trade-off is that the overall cost of hedging downside risk is cheaper, but upside potential is capped.
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Collar Option
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What Is A Collar Position? - Fidelity
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When to use Collar strategy?
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