The Put Options generally is ATM and the Call is OTM having the same expiration month and must be equal in the number of shares.
[ATM Put - At the Money: A Put Option is said to be in ATM if the strike price is equal to the current spot price of the security.
OTM - Out of the Money: A Call is said to be in OTM if the strike price is higher than the current spot price of the security.]
This is a low-risk strategy since the Put Options prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservatively bullish. The following example should make the Collar easier to understand:
Suppose you are holding ABC Ltd., at an average price of ₹4750. You also want to protect yourself from losses in case the stock moves downwards. In such a scenario, you can use the Collar strategy by selling a Call at ₹5000 for a premium of ₹40 and simultaneously buying a Put at ₹4700 for a premium of Rs 30. Both options will be for the same expiry date.
If the price of ABC Ltd. rises to Rs. 5100 after a month, then,
You will sell the stock at Rs. 5100 earning a profit of Rs. 350 (Rs. 5100 - Rs. 4750)
You will have to pay Rs. 100 when the call sold is exercised
The Put option will expire worthlessly
Net Profit = Rs. 350 - 100 + 40 - 30 = Rs. 260
This is the maximum return on the Collar Strategy
However, unlike a Covered Call, the downside risk here is also limited:
If the price of ABC Ltd. falls to Rs. 4400 after a month, then,
You lose Rs. 350 on the stock ABC Ltd. (Rs. 4750 - Rs. 4400)
The Call expires worthless
You will earn Rs. 300 when the Put option is exercised
Net loss = -350 + 300 - 30 + 40 = - 40
This is the maximum you can lose on the Collar Strategy. The Upside in this case is much more than the downside risk.
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