Collar
Description
A collar can be established by holding
shares of an underlying stock, purchasing a protective put and writing a
covered call on that stock. The option portions of this strategy are referred
to as a combination. Generally, the put and the call are both out-of-the-money
when this combination is established, and have the same expiration month. Both
the buy and the sell sides of this spread are opening transactions, and are
always the same number of contracts. In other words, one collar equals one long
put and one written call along with owning 100 shares of the underlying stock.
The primary concern in employing a collar is protection of profits accrued from
underlying shares rather than increasing returns on the upside.
P/L
Profile
Market Opinion
Neutral, following a period of appreciation
When to Use
An investor will employ this strategy after
accruing unrealized profits from the underlying shares, and wants to protect
these gains with the purchase of a protective put. At the same time, the
investor is willing to sell his stock at a price higher than current market
price so an out-of-the-money call contract is written, covered in this case by
the underlying stock.
Benefit
This strategy offers the stock protection
of a put. However, in return for accepting a limited upside profit potential on
his underlying shares (to the call's strike price), the investor writes a call
contract. Because the premium received from writing the call can offset the
cost of the put, the investor is obtaining downside put protection at a smaller
net cost than the cost of the put alone. In some cases, depending on the strike
prices and the expiration month chosen, the premium received from writing the
call will be more than the cost of the put. In other words, the combination can
sometimes be established for a net credit - the investor receives cash for
establishing the position. The investor keeps the cash credit, regardless of
the price of the underlying stock when the options expire. Until the investor
either exercises his put and sells the underlying stock, or is assigned an
exercise notice on the written call and is obligated to sell his stock, all
rights of stock ownership are retained.
Risk
vs. Reward
This example assumes an accrued profit from
the investor's underlying shares at the time the call and put positions are
established, and that this unrealized profit is being protected on the downside
by the long put. Therefore, discussion of maximum loss does not apply. Rather,
in evaluating profit and/or loss below, bear in mind the underlying stock's
purchase price (or cost basis). Compare that to the net price received at
expiration on the downside from exercising the put and selling the underlying
shares, or the net sale price of the stock on the upside if assigned on the
written call option. This example also assumes that when the combined position
is established, both the written call and purchased put are out-of-the-money.
Net Upside Stock Sale Price if
Assigned on the Written Call:
Call's Strike Price + Net Credit Received for Combination
or
Call's Strike Price - Net Debit Paid for Combination
Net Downside Stock Sale Price if Exercising the Long Put:
Put's Strike Price + Net Credit Received for Combination
or
Put's Strike Price - Net Debit Paid for Combination
If the underlying stock price is between
the strike prices of the call and put when the options expire, both options
will generally expire with no value. In this case, the investor will lose the
entire net premium paid when establishing the combination, or keep the entire
net cash credit received when establishing the combination. Balance either
result with the underlying stock profits accrued when the spread was established.
Break-Even-Point
(BEP)
In this example, the investor is protecting
his accrued profits from the underlying stock with a sale price for the shares
guaranteed at the long put's strike price. In this case, consideration of BEP
does not apply.
Volatility
If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies
The effect of an increase or decrease in
the volatility of the underlying stock may be noticed in the time value portion
of the options' premiums. The net effect on the strategy will depend on whether
the long and/or short options are in-the-money or out-of-the-money, and the
time remaining until expiration.
Time
Decay
Passage of Time: Effect Varies
The effect of time decay on this strategy
varies with the underlying stock's price level in relation to the strike prices
of the long and short options. If the stock price is midway between the strike
prices, the effect can be minimal. If the stock price is closer to the lower
strike price of the long put, losses generally increase at a faster rate as
time passes. Alternatively, if the underlying stock price is closer to the
higher strike price of the written call, profits generally increase at a faster
rate as time passes.
Alternatives
before expiration
The combination may be closed out as a unit
just as it was established as a unit. To do this, the investor enters a
combination order to buy a call with the same contract and sell a put with the
same contract terms, paying a net debit or receiving a net cash credit as
determined by current option prices in the marketplace.
Alternatives
at expiration
If the underlying stock price is between
the put and call strike prices when the options expire, the options will
generally expire with no value. The investor will retain ownership of the
underlying shares and can either sell them or hedge them again with new option
contracts. If the stock price is below the put's strike price as the options
expire, the put will be in-the-money and have value. The investor can elect to
either sell the put before the close of the market on the option's last trading
day and receive cash, or exercise the put and sell the underlying shares at the
put's strike price. Alternatively, if the stock price is above the call's
strike price as the options expire, the short call will be in-the-money and the
investor can expect assignment to sell the underlying shares at the strike
price. Or, if retaining ownership of the shares is now desired, the investor
can close out the short call position by purchasing a call with the same
contract terms before the close of trading.
Example
Suppose an options trader is holding 100
shares of the stock XYZ currently trading at $48 in June. He decides to
establish a collar by writing a JUL 50 covered call for $2 while simultaneously
purchases a JUL 45 put for $1. Since he pays $4800 for the 100 shares of XYZ,
another $100 for the put but receives $200 for selling the call option, his
total investment is $4700.On expiration date, the stock had rallied by 5 points
to $53. Since the striking price of $50 for the call option is lower than the
trading price of the stock, the call is assigned and the trader sells the
shares for $5000, resulting in a $300 profit ($5000 minus $4700 original
investment).
However, what happens should the stock
price had gone down 5 points to $43 instead? Let's take a look.At $43, the call
writer would have had incurred a paper loss of $500 for holding the 100 shares
of XYZ but because of the JUL 45 protective put, he is able to sell his shares
for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500
minus $4700 original investment).
Had the stock price remain stable at $48 at
expiration, he will still net a paper gain of $100 since he only paid a total
of $4700 to acquire $4800 worth of stock