0 The Collar Strategy



A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.

Collar Strategy Construction
Long 100 Shares
Sell 1 OTM Call
Buy 1 OTM Put

Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put.

The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.

Graph showing the expected profit or loss for the collar strategy option strategy in relation to the market price of the underlying security on option expiration date.
Collar Strategy Payoff Diagram

Limited Profit Potential
The formula for calculating maximum profit is given below:
  • Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Limited Risk
The formula for calculating maximum loss is given below:
  • Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
Breakeven Point(s)
The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.
  • Breakeven Point = Purchase Price of Underlying + Net Premium Paid
Example
Suppose an options trader is holding 100 shares of the stock XYZ currently trading at Rs48 in June. He decides to establish a collar by writing a JUL 50 covered call for Rs2 while simultaneously purchases a JUL 45 put for Rs1.
Since he pays Rs4800 for the 100 shares of XYZ, another Rs100 for the put but receives Rs200 for selling the call option, his total investment is Rs4700.
On expiration date, the stock had rallied by 5 points to Rs53. Since the striking price of Rs50 for the call option is lower than the trading price of the stock, the call is assigned and the trader sells the shares for Rs5000, resulting in a Rs300 profit (Rs5000 minus Rs4700 original investment).
However, what happens should the stock price had gone down 5 points to Rs43 instead? Let's take a look.
At Rs43, the call writer would have had incurred a paper loss of Rs500 for holding the 100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his shares for Rs4500 instead of Rs4300. Thus, his net loss is limited to only Rs200 (Rs4500 minus Rs4700 original investment).
Had the stock price remain stable at Rs48 at expiration, he will still net a paper gain of Rs100 since he only paid a total of Rs4700 to acquire Rs4800 worth of stock.


   

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