BAJAJ BROKING
April 01, 2025
9 mins read
A collar options strategy is a popular hedging technique investors use to protect gains or limit potential losses in an existing stock position. It involves three key components: holding the underlying stock, buying a protective put option, and selling a covered call option. This strategy aims to create a risk-management approach that limits downside risk while capping potential upside.
In a collar options strategy, the investor buys a put option to secure the right to sell the stock at a specific price (strike price), thus providing a safety net against a significant decline in the stock's value. Simultaneously, the investor sells a call option on the same stock, which generates premium income. The premium received from selling the call helps offset the cost of purchasing the protective put.
Here are key terminologies in options trading:
Option: A financial derivative arrangement that gives the holder the option—but not the responsibility—to buy or sell an underlying asset within a given time frame and at a fixed price.
Call Option: A contract that gives the buyer the right to acquire an underlying asset at a defined price (a strike value) within a given period.
Put Option: A put option is a financial contract that grants the buyer the right, but not the responsibility, to sell an underlying asset at a specific price within a certain term while gaining from price reductions.
Strike Price: The specified price at which the underlying asset can be acquired (call options) or sold (put options) when the option is exercised.
Expiration Date: The date when an options contract expires. If the option is not exercised by this date, it loses its value.
Premium: The price paid for an option, which is determined by factors such as the underlying asset's price, time until expiration, and market volatility.
In the Money (ITM): An option is considered to have inherent worth when its strike value is lower than the current price of the underlying asset. For a call option, this indicates the asset's price exceeds the strike price, but for a put option, it means the asset's price is less than the strike price.
Out of the Money (OTM): An alternative with no inherent worth. The price of the underlying asset is less than the strike price for a call option. The price of the underlying asset is more than the strike price for a put option.
At the Money (ATM): An option in which the strike price and the price of the underlying asset are identical.
Open Interest: The total number of outstanding options contracts that have not been settled or exercised. It helps gauge the liquidity and interest in a particular option.
Implied Volatility (IV): The market’s forecast of the likelihood of changes in the price of the underlying asset. Higher IV generally means higher option premiums.
Understanding these terms is essential for navigating the complexities of options trading and making informed investment decisions.
A collar options strategy is a widely used approach by traders to protect their investments while still allowing for some upside potential. It’s a risk-management strategy that helps limit potential losses on a long position. Let’s go through a collar options strategy example to see how it works in action.
Imagine you own 100 shares of a stock ABC, currently trading at $80 per share. You’re concerned about a possible market downturn but don’t want to sell your shares just yet. To safeguard your investment, you decide to implement a collar options strategy:
Buying a Put Option – You purchase a put option with a strike price of $75, which gives you the right to sell your shares at $75 if the stock price drops. Let’s assume this put option costs $3 per share, bringing the total cost to $300 (100 shares x $3 per share).
Selling a Call Option – To help offset the cost of the put option, you sell a call option with a strike price of $85. This means that if the stock price rises above $85, you’ll be obligated to sell your shares at this price. Suppose the premium received for selling this call option is $2 per share, giving you a total of $200 (100 shares x $2 per share).
The net cost of setting up the collar options strategy would be the cost of the put option minus the premium received from selling the call option. In this case, that’s $100 ($300 for the put option minus $200 from the call option premium).
Now, let’s look at the possible outcomes:
If the stock price remains between $75 and $85, neither option is exercised, and you simply keep holding your shares.
If the stock price falls below $75, you can exercise your put option, allowing you to sell the stock at $75 and limiting your loss to $8 per share ($80 current price – $75 strike price – $3 put option cost).
If the stock price rises above $85, your call option is exercised, and you must sell your shares at $85. This caps your profit at $7 per share ($85 strike price – $80 current price – $2 call option premium).
By using a collar, you create a defined range for both your risks and rewards. While it limits your profit, it also protects you from significant losses, making it an ideal strategy for uncertain market conditions.
Here’s a simple, easy-to-follow guide on how to set up a collar options strategy.
Step 1: Identify the Right Stock Position
The collar strategy is typically implemented on stocks that you already own or are planning to purchase.
Step 2: Sell a Call Option (Covered Call)
Choose a call option with a strike price above the current stock price (out-of-the-money).
Step 3: Buy a Put Option (Protective Put)
Choose a put option with a strike price below the current stock price (out-of-the-money).
Step 4: Analyze the Cost and Net Impact
The premium received from selling the call should offset part (or all) of the cost of purchasing the put.
Step 5: Monitor the Trade
If the stock price rises above the call strike price, your shares may be called away (sold).
If the stock price falls below the put strike price, the put option provides downside protection.
Adjust or roll the options if needed, based on market movement and expiration dates.
Step 6: Exit the Trade
If the stock remains between the call and put strike prices at expiration, both options expire worthless, and you keep the stock.
If the stock is above the call strike price, you may need to deliver the stock at that price (or buy back the call option).
If the stock is below the put strike price, you can exercise the put to sell the stock and limit your losses.
The collar options strategy is a well-balanced approach, but like any strategy, it comes with both benefits and drawbacks. Let’s break them down.
Advantages of the Collar Options Strategy
1. Limits Downside Risk
One of the biggest reasons traders use a collar strategy is to protect their investment from major losses. The put option acts as a safety net, ensuring that if the stock price drops below a certain level, you can still sell at the agreed strike price.
2. Reduces the Cost of Hedging
Hedging against risk usually comes at a price. However, with a collar, selling the call option helps offset the cost of buying the protective put. This makes it a more affordable strategy compared to simply purchasing a put option alone.
3. Ideal for Long-Term Investors
If you believe in the long-term potential of a stock but want to protect yourself from short-term volatility, a collar strategy is a great option. It allows you to hold onto your shares while managing risk, making it popular among conservative investors.
4. Provides Peace of Mind
With a collar in place, you don’t have to constantly watch the market or panic over price swings. You have a predefined range for both losses and gains, which helps remove emotional decision-making and keeps your investment strategy disciplined.
Disadvantages of the Collar Options Strategy
1. Caps Your Profit Potential
The biggest downside of using a collar is that it limits how much you can earn. This means if the stock experiences a huge rally, you won’t benefit beyond the call option’s strike price.
2. Requires an Active Approach
While a collar reduces risk, it still requires active management. You need to choose appropriate strike prices for the put and call options and monitor your position as expiration approaches.
3. Limited Use in Certain Market Conditions
A collar strategy works effectively when the stock is expected to move within a defined range. If the stock is highly volatile, the cost of the put option may be too high, making the strategy less attractive. On the other hand, if the stock barely moves, you may feel like you restricted your profits unnecessarily.
Suppose you own 100 shares of ABC stock, currently trading at $60 per share. To protect against downside risk while generating income, you implement a collar options strategy:
Sell a covered call: You sell a $65 strike call option expiring in one month for $2 per share ($200 total).
Buy a protective put: You buy a $55 strike put option expiring in one month for $1.50 per share ($150 total).
Net credit: You receive $0.50 per share ($50 total) from the option trade.
Outcome Scenarios
Stock rises above $65: Your shares are sold at $65, locking in profits.
Stock drops below $55: The put protects you by allowing you to sell at $55.
Stock stays between $55-$65: Both options expire worthless, and you keep your stock and the net credit.
This strategy provides downside protection while allowing some upside potential.
A collar options strategy is often used when you already own or plan to acquire shares and want to protect your investment from significant downside risk while still capturing some upside potential. It’s especially useful in situations where:
Market Uncertainty: You expect the market or stock to be volatile or face short-term declines.
Profit Protection: Your stock has appreciated, and you want to lock in gains without selling your position.
Risk Management: You want insurance against steep losses while being willing to cap your profit.
Income Generation: Selling the call helps generate premium income to offset the cost of buying the put.
Moderate Outlook: You have a neutral to moderately bullish outlook, meaning you don’t expect extreme upward movement.
The collar options strategy is an effective way to hedge against downside risk while allowing for some upside potential. By combining a protective put and a covered call, investors can safeguard their profits while reducing hedging costs. This strategy is particularly useful in uncertain markets or when you want to lock in gains without selling your stock.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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A collar options strategy is a risk-management approach where an investor holds stock, buys a protective put, and sells a covered call to limit downside risk while capping upside potential.
The protective put allows the investor to sell the stock at a predetermined price, ensuring losses don’t exceed a certain level, while the covered call offsets costs, reducing overall hedging expenses.
Yes, but profits are capped. Gains are limited to the call option’s strike price, minus premiums, while downside risks are mitigated by the put option, creating a defined risk-reward range.
The primary risks include capped profits, potential early assignment of the call, and costs associated with buying the put, which can reduce net returns if the stock remains stable.
Investors should use a collar when they want downside protection, have profits to secure, expect market volatility, or wish to hedge risk while maintaining stock ownership without immediate liquidation.
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