A Collar is similar to a Covered Call with limited risk (Strategy 6) – buying Put Options to insure against the fall in the price of the stock. So a Collar is buying a stock, insuring against the downside by buying Put Options, and then partly financing the Put Options by selling a Call.
The Put Options generally are 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 prevent 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:
When to Use: The collar is a good strategy to use if the investor is writing covered calls to earn premiums but wishes to protect himself from an unexpectedly sharp drop in the price of the underlying security.
Risk: Limited.
Reward: Limited.
Breakeven: Purchase Price of Underlying – Call Premium + Put Premium.
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 ₹30. Both options will be for the same expiry date.
1. If the price of ABC Ltd. rises to ₹5100 after a month, then:
- You will sell the stock at ₹5100, earning a profit of ₹350 (₹5100 - ₹4750)
- You will have to pay ₹100 when the call sold is exercised
- The Put option will expire worthlessly
- Net Profit = ₹350 - ₹100 + ₹40 - ₹30 = ₹260.
This is the maximum return on the Collar Strategy.
However, unlike a Covered Call, the downside risk here is also limited.
2. If the price of ABC Ltd. falls to ₹4400 after a month, then:
- You lose ₹350 on the stock ABC Ltd. (₹4750 - ₹4400)
- The Call expires worthless
- You will earn ₹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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