A Guide to Collars in Options Trading
A collar is an options strategy used by traders to protect themselves against heavy losses. The strategy, also known as a hedge wrapper, involves taking a long position in an underlying stock, buying an out-of-the-money put, and selling an out-of-the-money call.
Essentially 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. While collars in options protect against heavy losses, they also limit potential gains. Read on to learn more about collar breakeven points, max loss, and max profit.
What Is a Collar Option?
In collar options strategies, an options trader limits the range of their returns by taking a long position in the underlying stock, buying a lower strike put, and selling a higher strike call. Typically, the stock price will be between the two strike prices. A trader uses a collar when they are bullish on the underlying stock but want to be protected against the risk of large losses.
A collar is also a useful option strategy when the goal is to protect unrealized gains on the stock.
How Do Collars Work?
A collar works by protecting a trader’s existing long stock position by buying a put option, limiting any further losses should the stock price fall below the strike of the put. At the same time, the sale of an out-of-the-money call helps finance the trade, making the cost of protection cheaper than purchasing a put on the underlying shares, with the trade-off that gains will be capped should the stock rise above the strike of the call. The 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 stock position.
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 obligates the writer to sell the stock at the call’s strike if the option is assigned. Meanwhile, the trader remains long shares of the underlying stock.
Maximum Profit
The short call position in a collar option strategy caps upside, limiting the maximum potential profit. The max profit depends on if the investor established the options trade at a net debit or a net credit.
• Net debit: Maximum profit = Call strike price – stock price – net debit, or
• Net credit: Maximum profit = Call strike price – stock price + net credit = max profit
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. So either
• Net debit: Maximum loss = Stock price – put strike price – net debit paid, or
• Net credit: Maximum loss = Stock price – put strike price + net credit received
Breakeven Points
Once established, a collar option has two possible break even points – again, dependent on whether the trade was executed at a net credit or debit.
• Net debit: Break even point = current stock price + net debit, or
• Net credit: Break even point = current stock price – net credit
Impact of Price Changes
A collar keeps a trader’s long-term bullish stance but it protects unrealized profits from a short-term share price decline. 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 because the trader has simultaneous long and short option positions. The collar trade usually has a near-zero vega.
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 works to the trader’s benefit when the underlying stock price rallies up to the short call’s strike. On the flip side, the impact of time hinders the trade when the stock price nears the long put’s strike. 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.
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 some risk of loss |
| Cheaper than only buying puts | Can be a complicated strategy for new traders |
| Ownership of the stock retained |
Collar Option Examples
Here’s a collar option example that will help put these concepts into context: Suppose a trader is long shares of XYZ stock that currently trades at $100. The trader worries about limits to near-term upside and wants to protect against a material share price decline. A collar strategy is a good trade to address these beliefs.
The trader sells a covered call at the $110 strike, receives a $5 premium, and buys a protective put at the $90 strike at a cost 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 and the downside at the put’s strike. The breakeven point is $99 (the current stock price minus the net credit).
Let’s say the stock rallies to the call’s strike by expiration. In this case, the trader makes $10 on the long stock position, keeps the $5 call premium, and lets the put expire worthless. The gain is $11 (the stock price gain plus the options’ net credit received).
If the stock price drops to $80, the trader loses $20 on the stock position, keeps the $5 call premium, and makes $6 on the $90 strike long put. Thus, the net loss is just $9. The trader benefitted from the collar as opposed to just owning the stock which was 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
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 protects a trader from 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
A collar is a strategy whereby a trader protects an unrealized gain on a stock at a reduced cost while still allowing some upside equity participation. Traders might use this strategy for tax purposes, or to limit the overall risk in their portfolio.
While SoFi does not currently offer options traders, it does help investors learn more about options. Investors can also get started by opening a brokerage account on the SoFi Invest investment platform where you can build a portfolio of stocks and exchange-traded funds.
FAQ
What is the maximum profit on a collar option?
The maximum profit on a collar is when the stock price rallies up to the call’s strike price. Above that level, gains are constant since the long stock position is offset by the short call.
Maximum profit = (call option strike price – net of option premiums) – stock purchase price
What is maximum loss on a collar option?
The maximum loss on a collar option trade is when the stock price declines to the put’s strike price. Below that level, losses are limited since the long stock position is offset by the long put.
Maximum Loss = stock purchase price – (put option strike price – net of option premiums)
What is breakeven on a collar option?
The breakeven on a collar strategy at expiration is the current stock price minus the net credit received or the current stock price plus the net debit paid.
Breakeven = stock price + put option premium paid – call option premium received
Photo credit: iStock/gorodenkoff
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