Collar Option Strategy: How to Protect Your Portfolio
The collar option strategy can be used to protect profits or limit losses on an underlying asset. This strategy involves the simultaneous purchase of a protective put option and the sale of a covered call option on the same asset. By doing so, investors can create a "collar" that limits the asset's price movement within a specific range.
The collar option strategy is useful because it allows investors to balance risk and reward. By protecting against potential losses while still generating income, the collar option strategy can be useful for investors looking to manage their portfolio risk.
What is the Collar Option Strategy?
The collar option strategy is a complex trading strategy that involves multiple components. It begins with purchasing a protective put option, which gives the investor the right to sell the underlying asset at a predetermined price. This put option provides downside protection and limits the investor's potential losses.
At the same time, the investor sells a covered call option on the same asset. The sale of this call option generates income for the investor but also limits the potential profit they can make on the underlying asset.
The sale of the call option will generally cover the costs of buying the put option making the put “free.” However, if the stock moves up, the put option will lose all its value, negating more upside potential.
Is the Collar Option Strategy Bullish or Bearish?
The collar strategy involves holding stock, selling a covered call, and buying a put. The combination of these trades is bullish, but the options side of the collar is bearish.
Of course, long shares of stock are bullish, but a long put is bearish, and a short call is also bearish. However, the shares outweigh the options when trading the collar, making it an overall bullish strategy.
The collar option strategy can be used in both bullish and bearish markets. In a bullish market, investors can use the strategy to protect their gains while still participating in the upside potential of the underlying asset. In a bearish market, investors can use the strategy to limit their losses while still generating income.
Collar Option Strategy Breakeven Point & Payoff Diagram
The collar option strategy can be put on for a debit or a credit. If you put it on for a credit, the breakeven point is the credit subtracted from the underlying stock price.
For example, if you own a stock at $100 and put on a collar for a $0.50 credit, your breakeven point will be $99.50.
On the other hand, if you put on a collar option strategy for a $0.50 debit, your breakeven will be $100.50.
Example of a Collar Option Strategy
To illustrate how the collar option strategy works, let's consider a hypothetical scenario. Suppose an investor purchases 100 shares of XYZ stock at $50 per share. They then buy a protective put option with a strike price of $45 and sell a covered call option with a strike price of $55.
If the price of XYZ stock remains between $45 and $55, the investor's loss will be limited to the premium they paid for the protective put option. If the stock price rises above $55, the investor's profit will be limited to the difference between the sale price of the stock and the call option's strike price of $55. If the stock price falls below $45, the investor can sell the stock at the put option's strike price of $45, limiting their losses.
How do Collars Make Money?
The collar option strategy can make money whether the stock moves up or down. If the stock increases, you will lose money on the options, but the stock will generate a profit.
If the stock decreases, your shares will lose money, but the put and covered call will likely make money. However, there are several factors to consider, such as implied volatility changes and how much the stock drops.
If the stock stays flat, you will lose money on the put due to theta decay but will make money on the covered call, which negates the losses from the put option.
Consider this article about the collar options strategy for more research.
