Collar option strategy

Submitted by admin on Thu, 11/25/2021 - 22:20

As a temporary, somewhat less-than-complete hedge against the impacts of a likely near-term collapse, the investor adds a collar to an existing long stock position.

Description


To hedge a long position in the underlying stock, an investor writes a call option and buys a put option with the same expiration.
Protective puts and covered call writing are two more hedging tactics included in this approach.


Typically, the investor will choose a call strike above the opening stock price and a long put strike below it.
There is some flexibility, but the strike selections will influence the hedge's cost as well as the protection it offers.
The 'bottom' and 'ceiling' of the position are referred to as the 'floor' and 'ceiling,' respectively, and the stock is 'collared' between the two strikes.


In the event that the investor needs to liquidate during a downturn, the put strike specifies a minimum exit price.


The call strike establishes a ceiling on stock gains.
If the stock rises over the call strike, the investor should be ready to sell the shares.


The investor obtains a minimum price at which the stock can be sold during the life of the collar in exchange for accepting a cap on the stock's upward potential.


Outlook


The investor expects a modest increase in the stock price throughout the duration of the option strategy, but is concerned about a decrease.


EXAMPLE


AAPL is a stock that I own 100 shares of.

1 AAPL 165 call is sold short.

1 AAPL 120 put long


GAIN MAXIMUM


OR call strike - acquisition price of shares - net premium paid
Stock purchase price + net credit received = call strike


LOSS MAXIMUM


OR the stock purchase price minus the put strike minus the net premium paid OR the stock purchase price minus the put strike minus the net premium paid
Purchase of stock minus put strike + net credit received


Summary


As a temporary, somewhat less-than-complete hedge against the impacts of a likely near-term collapse, the investor adds a collar to an existing long stock position.
The stock's lowest selling price is determined by the long put strike, while the maximum profit price is determined by the short call strike.
A long call and a short put might be used to protect or collar a short stock position.

Motivation


This approach is for stockholders or buyers who are concerned about a stock's price dropping and want to protect their long stock position.

Variations


Maximum Loss: N/A


For the duration of the collar hedge, the maximum loss is restricted.
The worst-case scenario is that the stock price falls below the put strike, causing the investor to execute the option and sell the shares at the put strike's 'floor' price.
This exit price could potentially result in a profit if the stock was initially purchased at a considerably lower price (which is typically the case for a long-term ownership).
The brief call would be meaningless when it came to an end.


The difference between the floor price and the stock purchase price, plus (minus) the debit (credit) from forming the collar hedge, would be the real loss (profit).

Maximum Gain


For the duration of the strategy, the maximum gain is capped.
Just as the stock price climbs to the call strike, the short-term maximum gains are realised.
No matter how much higher the stock closes, the net profit stays the same; only the position outcome may alter.


If the price is above the call strike at expiry, the investor will almost certainly be assigned to the call and liquidate the stock at the call strike's 'ceiling.'
The profit would be calculated as the ceiling price less the stock purchase price plus (minus) the credit (debit) from the collar hedge.


The stock would expire worthless if it closed exactly at the call strike, and the stock would most likely remain in the account.
The profit/loss up to that point would remain similar, but the investor would still be subject to the same risks and rewards as a stockowner from that point forward.

Profit/Loss


For the duration of the plan, this approach establishes a defined level of price exposure.
If the stock loses value, the long put gives a suitable exit price at which the investor may liquidate.
The premium revenue from the short call helps pay for the put, but it also puts a cap on the potential upside return.


Depending on the disparity between the strikes, both the possible profit and loss are relatively restricted.
Profit potential isn't the most important factor here.
After all, this is a hedging technique.
The major concerns of the protective collar investor are how to strike a balance between the amount of protection and the cost of protection over a worrying time.

Breakeven


In theory, the approach breaks even if the stock is above (below) its beginning level by the amount of the debit at expiration (credit).
The idea of breakeven is irrelevant if the stock is a long-term investment acquired at a considerably lower price.

Volatility


All else being equal, volatility is typically not a key factor in this technique.
The impact of implied volatility changes may be countered to a substantial degree because the strategy includes being long one option and short another with the same expiration (and typically equidistant from the stock value).

Time Passes


Normally, this isn't a huge consideration.
The impacts of time decay should nearly equal each other because the strategy includes being long one option and short another with the same expiry (and typically equidistant from the stock value).

Assignment Danger


Yes.
While early assignment of a short call option is feasible at any time, it is most common right before the stock's ex-dividend date.


Also, be aware that if a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, usual expectations for early execution of options on the stock may be entirely thrown off.

Risk of Expiration


Until the following Monday, the option writer will have no way of knowing whether or not the assignment was completed during the short call.
However, because the investor has shares to deliver if the call is assigned, this is usually not an issue.


This method is well suited for use as a LEAPS hedge, as time value tends to raise premiums and extend the protection duration.
The collar provides more protection than a covered call while costing less up front than a protected put.
For further information, look into both of these options.