What Is a Collar?

A collar, also known as a hedge wrapper or risk-reversal, is an options strategy used to protect against significant losses but also limits your potential profits. It's used when you're optimistic about a stock you own long-term but worry about short-term volatility in the market. An investor who already owns an underlying a stock (or other asset) creates a collar by buying an out-of-the-money put option, which protects against the stock price going down. At the same time, the investor writes an out-of-the-money call option, where the current price is lower than the option's strike price. This produces income from selling the call option, which hopefully at least covers the cost of buying the put option. It also allows the trader to profit on the asset up to the call's strike price, but not higher. Thus, the strategy caps the potential profit at the call option's strike price. As such, while the collar options strategy can protect against significant losses, it limits potential gains. We explain in this more and clearer detail below.

Understanding a Collar

Investors typically use collars if they own a stock whose value is higher than when they bought it, and they are optimistic about the stock going up but unsure of its shorter-term prospects. To protect their gains against a downside move in the stock, they can carry out the collar option strategy. The best outcome for an investor is when the stock's price matches the set price of the call option they've sold right when the option is about to expire.

The collar strategy combines two methods: buying a put to protect against price drops and selling a call to earn some money upfront. Let's break this down:

• Buying a put (also called a protective or married put): This is like having insurance on your stock. If the stock's price falls, you can sell it at a preset price, protecting you from significant losses.
• Selling a call (also known as a covered call): This is where you agree to sell your stock at a specific price in the future. In return, you get paid now. This payment can help cover the cost of the put option you bought.

Here's your checklist for carrying this out:

• Both the put and the call options should end in the same month, and you should have the same number for each.
• The price you can sell your stock with the put should be lower than its current price.
• The price at which you agree to sell your stock with the call should be higher than its current price.
• The money you make from selling the call should cover the cost of buying the put, so you don't have to spend extra money.

This setup is ideal if you don't want to spend extra money and are fine with not getting the profits should the stock go up higher than you thought. Thus, this is not the best choice if you're very bullish on a stock.

A fence is a similar risk-reversal strategy that uses three option actions.

Collar Break-Even Point and Profit or Loss

For investors using a collar strategy, their break-even point is calculated by looking at the difference between what they spent and what they earned from the options. When they end up with more money from the options than they paid, a net credit, they add this extra to the stock's purchase price. If they spent more on the options than they got back, a net debit, they subtract this from the stock's purchase price. You need the stock to end at this final number so you break even.

• Breakeven (if a debit) = Stock Purchase Price + Net Premium Paid
• Breakeven (if a credit) =Stock Purchase Price - Net Premium Collected

The most investors can make from a collar strategy is found by looking at how high the call option's preset sell price is above what they originally paid for the stock after considering the costs or gains from dealing with the options. The biggest loss they can face is the difference between what they paid for the stock and the safety net price set by the put option, again after accounting for the options' costs or gains. How to calculate this is below for each possible outcome:

• Maximum Profit (if a debit) = Call Strike - Stock Purchase price - Net Premium Paid
• Maximum Profit (if a credit) = Call Strike - Stock Purchase Price + Net Premium Collected
• Maximum Loss (if a debit) = Put Strike - Stock Purchase Price - Net Premium Paid
• Maximum Loss (if a credit) = Put Strike - Stock Purchase Price + Net Premium Collected

Protective Collar Example

Suppose you own 100 shares of stock ABC, bought originally at $80 per share, and the stock is trading at $87 per share. You want to temporarily hedge the position since there's been volatility in the overall market.

You buy one put option (note that one stock option contract is 100 shares) with a strike price of $77 and a premium of $3.00. You also write (sells) one call option with a strike price of $97 with a premium of $4.50.

Cost or Credit to Put on the Collar

When you start the collar strategy in the above scenario, you receive a net credit of $1.50 per share, and $1.50 × 100 = $1,500. This is because you sold the call for $1.50 more than you paid for the put, and you pocket that difference for now.

Breakeven Point

Let's also look at what it would take to break even: Breakeven = Underlying Cost + Put Cost – Call Premium Received = $80 + 3.00 - 4.50 = $78.50 in the stock price

Maximum Profit

Let's now calculate the best upside you would see with this strategy: Maximum Profit for a credit collar = Call Strike - Stock Purchase Price + Net Premium Paid = 97 - 80 + 1.50 = 18.50 × 100 shares per contract = $1,850

Maximum loss

Lastly, let's look at the worst possible outcome: Maximum Loss for a credit collar = Put Strike - Stock Purchase Price + Net Premium Collected

= 77 - 80 + 1.50 = -1.5 × 100 shares per contact = -$150

Pros and Cons of a Collar Strategy

This strategy appeals to investors seeking to protect their long positions against market volatility or downside risk. However, like all investment strategies, it has its benefits and drawbacks.

A collar is worthwhile when an investor is looking to protect gains on a stock that has appreciated in value but is concerned about a potential short-term downturn in the market. So, a collar is helpful if you are moderately bullish or neutral on the stock and want to hedge against potential downside risk without costing too much. But if you're very bullish on a stock, you are limiting profits you anticipate are possible. It's likewise a promising approach for investors comfortable capping their upside potential in exchange for downside protection. This makes it a fitting strategy for conservative investors or those approaching a financial goal when preserving gains is more important than achieving potentially higher returns.

The main downside to a collar is that it does cap upside gains if the underlying asset continues to rise past the call's strike price. Meanwhile, if the stock price does not fall to the put strike price level, the put option's cost would have been an unnecessary expense.

The Bottom Line

A collar is a defensive options strategy used to protect against downside losses while limiting upside gains. Investors and traders can use collar options for interest rate risks as well as losses from holding a long position on a stock.

It is essentially the combination of a protective put with a covered call. To perform the strategy, you would already own a stock and be moderately bullish about its price outlook. You would then buy a downside put and sell an upside call, effectively "collaring" the position between the two strike prices. If the stock drops, the put creates a floor, preventing further losses, while the short call provides some additional income to offset the initial cost of the put. If the stock rises, the put expires worthless and the short call will limit further upside beyond its strike price (plus any net credit received for selling it).