Understanding the Collar Strategy in Options Trading

Financial derivative conferring the right to to buy or sell a certain thing at a later date at an agreed price.

The Collar strategy, also known as the hedge wrapper, is a defensive options trading strategy that is used when the investor wants to protect against a potential loss in a stock that they own. This strategy involves holding the stock, purchasing a protective put and writing a covered call.

Benefits of Using the Collar Strategy

The Collar strategy is primarily used for two purposes: to limit losses and to protect profits. If you own a stock that has increased in value, you can use this strategy to protect your unrealized profits against a potential drop in the stock price. On the other hand, if you own a stock that has not yet increased in value, you can use this strategy to limit your potential losses.

Implementing the Collar Strategy in Your Trading

To implement the Collar strategy, you need to own the underlying stock. Then, you buy a put option for the same stock. The strike price of the put option should be below the current price of the stock. This put option gives you the right to sell the stock at the strike price, thus protecting you from a drop in the stock price.

At the same time, you write a call option for the same stock. The strike price of the call option should be above the current price of the stock. This call option obligates you to sell the stock at the strike price if the stock price increases and the option is exercised. The premium received from writing the call option can offset the cost of buying the put option.

Risks and Potential Downsides of the Collar Strategy

While the Collar strategy can protect against losses, it also limits potential gains. If the stock price increases significantly, you are obligated to sell the stock at the strike price of the call option, thus capping your potential profit.

Moreover, the Collar strategy involves costs. You need to pay the premium for the put option, although this can be offset by the premium received from writing the call option. However, if the stock price remains stable, both options will expire worthless, and you will lose the net premium paid.

Case Studies of Successful Collar Trades

Consider a case where you own 100 shares of a company, currently trading at 50 per share. You could buy a put option with a strike price of 45 and write a call option with a strike price of 55. If the stock price drops to 40, your loss is limited to 5 per share, thanks to the put option. If the stock price increases to 60, your gain is capped at $5 per share, due to the call option. In either case, the Collar strategy has helped you manage your risk.