Options Collar: How the Strategy Works and Examples
A collar is an options strategy used by traders to try to protect themselves against heavy losses. The strategy, also known as a hedge wrapper, is a risk-management options strategy that involves taking a long position in an underlying stock, buying an out-of-the-money (OTM) put, and selling an OTM call.
With an option collar, you’re buying a protective put and a covered call at the same time on a stock that you already own or have long exposure to. Although options collars are designed with the aim to protect against losses, they may also limit any potential gains. Investors need to consider a collar’s break-even point, maximum risk of loss, and maximum potential profit.
Key Points
• Options collar strategy involves buying a protective put and selling a covered call to limit losses and gains on a stock.
• The strategy is used to protect unrealized gains while allowing some upside potential.
• Maximum profit and loss depend on whether the trade is executed at a net credit or debit.
• Time decay and volatility have specific impacts on the strategy, affecting option prices and potential outcomes.
• Collar options are effective for managing risk and protecting assets without selling stock positions.
What Is an Options Collar?
An options collar is designed to manage risk by buying a put option and selling a covered call option at the same time for the same underlying stock. Investors may use this options trading strategy when they want to potentially limit losses on a stock they own, even if it means putting a limit on potential gains.
Typically, the stock price will be between the two strike prices: the high price on the covered call, and the low price on the put option. An options trader uses a collar when they are bullish on the underlying stock but want to be protected against the potential risk of large losses.
A collar is also a useful option strategy when the goal is to protect unrealized gains on a stock.
How Options Collars Work
With a collar option strategy, a trader aims to protect their long stock position by buying a put option, limiting any further losses should the stock price fall below the put’s strike price. Traders also sell an out-of-the-money call option for more than the stock’s current price. This caps potential gains, but it may also help reduce the cost of protection when compared to the premium of a standalone put on the underlying shares. This comes with the trade-off of capped gains, however: any increase in value beyond the strike price will not be realized.Buying a put gives the trader the right (but not the obligation) to sell the stock at the put’s strike price. Selling the call requires the writer to sell the stock at the call’s strike price, if it is assigned. In the meantime, the trader remains long on the shares of the underlying stock.
A trader constructs a collar through their brokerage when they think there could be near-term weakness in the stock but do not want to sell their position.
Maximum Profit
The short call position in a collar option strategy caps upside, limiting the maximum potential profit. The maximum profit depends on whether or not the investor establishes the options trade at a net debit (upfront expense) or a net credit (upfront income).
• Net debit: Maximum profit = Call strike price – Stock purchase price – Net premium paid
or
• Net credit: Maximum profit = Call strike price – Stock purchase price + Net premium received
At a high level, the trader makes the most money when the stock price is at or above the call’s strike at expiration.
Maximum Loss
The protective put limits losses in the event the underlying share price falls below the put’s strike. This is calculated in one of two ways:
• Net debit: Maximum loss = Stock purchase price – Put strike price – Net debit paid
or
• Net credit: Maximum loss = Put strike price – Stock purchase price + Net premium received
Break-even Points
Once established, a collar option has two possible break even points – again, depending on whether the trade was executed at a net credit or debit.
• Net debit: Break-even point = Stock purchase price + Net premium paid
• Net credit: Break-even point = Stock purchase price + Net premium collected
Pros and Cons of Collars
| Pros | Cons |
|---|---|
| Limits losses from a falling share price | Limits gains from a rising share price |
| Allows for some upside exposure | Exposes the trader to risk within the range of the collar |
| Cheaper than only buying puts | Can be a complicated strategy for new traders |
| Ownership of the stock retained | Early assignment risk may disrupt the strategy’s effectiveness |
Options Collar Examples
Suppose a trader is long shares of XYZ stock that currently trades at $100. The trader is concerned about limited near-term upside and wants to avoid the risk of a significant decline in share price. A collar strategy might help with these concerns.
The trader sells a covered call at the $110 strike price, receives a $5 premium, and also buys a protective put at the $90 strike price of $4. The net credit is $1 and the trader has not paid any commissions.
With these two options trades, the trader has capped their upside at the call’s strike price and the downside at the put’s strike. The breakeven point is $99 (the current stock price, minus the net credit from the premium).
Let’s say the stock rallies to the call’s strike by expiration. In this case, the trader realizes value on the long stock position, keeps the $5 call premium, and lets the put expire worthless. The gain is $11 (the stock price’s gain plus the option’s net credit received.
If the stock price drops to $80, the trader loses $20 on the stock position, keeps the $5 call premium, and $6 gain on the $90 strike long put. Thus, the net loss is $9. The trader benefitted from the collar as opposed to just owning the stock, which went down $20. The payoff diagram below shows how losses are limited in our trade scenario, but gains are also capped at the $110 mark.
Collar Payoff Diagram
Factors That Impact an Options Collar
There are three main factors that can impact the outcome of a collar.
Impact of Price Changes
A collar keeps a trader’s long-term bullish stance while seeking to protect unrealized profits from a short-term decline in share price. If the underlying stock price rises, the collar provides some exposure to upside gains, capped at the short call’s strike. The real value of a collar comes if the stock price drops through the long put strike: the collar protects the trader from further losses.
Another way to look at the impact of price changes is to view it from a perspective of time. A collar can help a trader with a short-term bearish outlook but a bullish long term view. Collars have a positive Delta.
Impact of Volatility Changes
Changes in volatility have a relatively smaller impact on a collar options strategy versus other options trades. This is because the trader has simultaneous long and short option positions. The collar trade usually has a near-zero vega, a calculation that measures an option’s sensitivity to the underlying asset’s volatility.
Recommended: What Are the Greeks in Options Trading?
Impact of Time
With a collar options trade, the effect of time decay depends on how close the stock price is to the option strike prices. Time decay demonstrates the loss in value that an option has as it nears expiration.
Time decay benefits the trader when the underlying stock’s price approaches the short call’s strike price. The option’s extrinsic value decreases as it approaches expiration, which can reduce the potential of assignment.
On the flip side, time decay may work against the trader if the stock price nears the long put’s strike, as the put’s extrinsic value gradually decreases approaching expiration. However, if the stock price stabilizes near the strike price, the option retains intrinsic value, which offsets the impact of time decay, unless the put expires worthless.
When the stock price is about equally between the two strikes, time decay is neutral since both option prices erode at approximately the same rate. So, while the short put value drops, the long call offsets those gains from time decay.
Reasons to Consider Using a Collar Option Strategy
A collar is an effective strategy when an investor expects a stock to trade sideways or down over a period. A trader might also use it when they expect a stock to go up over time and do not want to sell their shares, but they do want to protect unrealized gains – perhaps for tax reasons. A collar option trade is less bearish than buying puts outright, but it may still offer a hedge against large losses. Also, selling the upside call helps finance the protective position.
Limiting Risk
A collar option strategy limits risk beyond the protective put’s strike. Even if a stock price goes to zero, the trader’s loss maxes out at the protective put’s strike.
Protecting an Asset
Another way to protect your stock position is to implement a protective put. With a protective put, a trader buys a put in addition to their long position in the underlying stock. This trade would be more expensive than a collar, since there is no sale of a call option to offset the cost of buying the put, but retains the unlimited upside of the underlying stock position.
The Takeaway
An options collar is a strategy in options trading whereby a trader protects an unrealized gain on a stock at a reduced cost while still allowing some upside equity participation. This strategy is commonly used by traders engaging in online investing to manage risk. Traders might implement a collar for tax purposes or to limit the overall risk in their portfolio.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
Are options collars bearish or bullish?
An options collar strategy is neither strictly bearish nor bullish. It is typically a neutral-to-slightly-bullish strategy because it provides downside protection through the put option while allowing limited upside potential via the call option. This makes it a common option for investors who are cautiously optimistic but want to hedge against significant downside risk.
What is the benefit of an options collar strategy
An options collar strategy offers downside protection by way of a put option while reducing costs by selling a call option. It also allows investors to retain ownership of the underlying stock. This strategy could help mitigate risk and potentially create more portfolio stability.
What is the opposite of an options collar?
The opposite of an options collar strategy can be considered one of several moves: a naked position, which is an options contract with no offsetting position, or an unhedged long or short stock position, which means holding a financial asset without risk management strategies in place (e.g., other options or futures contracts) to protect against downward price movements.
What is the risk of an options collar?
Options collars come with several potential downsides. There is limited upside potential due to the sale of the out-of-the-money call option, limited risk reduction since a collar does not protect against losses entirely, and early assignment risk, which occurs when the call option buyer exercises their right to purchase the stock before the option’s expiration, potentially disrupting the strategy.
Photo credit: iStock/gorodenkoff
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