Options Collar Strategy
Collars are a popular options trading strategy that is often used by investors to limit their downside risk while also potentially benefiting from an increase in the price of the underlying asset. This strategy involves the simultaneous purchase of a put option to limit potential losses and the sale of a call option to generate income.
In this article, we’ll delve into the basics of collars in options trading, including how they work, when to use them, and their advantages and disadvantages. Whether you’re a beginner or an experienced trader, understanding collars can help you make better investment decisions and manage your portfolio more effectively.
What Is an Options Collar?
A collar is an options trading strategy that involves buying a protective put option and selling a covered call option at the same time. The purpose of a collar is to limit the potential downside risk of an underlying asset while also potentially generating income.
The protective put option provides the investor with the right to sell the underlying asset at a specified price (known as the strike price) within a certain time frame. This provides downside protection because if the price of the underlying asset falls below the strike price, the investor can exercise the put option and sell the asset at the higher strike price.
The covered call option, on the other hand, involves selling the right to buy the underlying asset at a specified price (the strike price) within a certain time frame. This generates income for the investor, but also limits the potential upside gain from the underlying asset.
The premium received from selling the call option can offset the cost of buying the put option. This can result in a net credit if the sold call is more expensive than the purchased put, a net debit if the purchased put is more expensive than the sold call, or a zero-cost collar if the sold call and purchased put are the same prices.
Here are a few reasons why someone might choose to trade an options collar:
- Protect against downside risk: One of the primary reasons to trade an options collar is to protect against downside risk in a long stock position. By buying a put option with a strike price below the current stock price, you can limit your potential losses if the stock price drops. If the stock price falls below the strike price of the put option, you have the right to sell your shares at that price, limiting your losses.
- Generate income offsetting the premium of the protective put: Another reason to trade an options collar is to generate income that offsets the cost of buying the protective put option. By selling a call option with a strike price above the current stock price, you can receive a premium that helps offset the cost of buying the put option. This can reduce the overall cost of hedging your position and make it more affordable.
- Lock in profits: If you have a long stock position that has increased in value, you may want to lock in some of those profits while still maintaining exposure to potential future gains. By selling a call option with a strike price above the current stock price, you can lock in a profit if the stock price rises to that level. If the stock price remains below the strike price of the call option, you keep your shares and can continue to benefit from any future gains.
- Manage risk in volatile markets: Options collars can also be used to manage risk in volatile markets. If you’re concerned about a potential market downturn or other market events that could impact your portfolio, an options collar can help you limit your downside risk while still maintaining exposure to potential upside gains.
Options Collar Example
Let’s say you own 100 shares of XYZ stock that you purchased for $50 per share. You want to protect your position against a potential decline in the stock’s price, but you also don’t want to sell your shares right now. You decide to use an options collar to protect your position.
To create the collar, you could do the following:
- Buy a put option with a strike price of $45 for $1 per share. This gives you the right to sell your shares at $45 per share if the stock price drops below that level.
- Sell a call option with a strike price of $55 for $2 per share. This obligates you to sell your shares at $55 per share if the stock price rises above that level.
Since the premium you received for selling the call option is higher than the premium you paid for the put option, you receive a net credit of $1 per share.
Now let’s look at the max profit potential and max loss potential of this trade:
- Maximum profit potential: This occurs if the stock price rises to or above the strike price of the call option and you are obligated to sell your shares at that price. In that scenario, you gain the difference between the call option strike price ($55) and the per share price you paid for the stock ($50), plus the net credit premium ($1), multiplied by the number of shares (100) for a max profit of $6 per share ($600 total).
- Maximum loss potential: This occurs if the stock price falls to or below the strike price of the put option at expiration. In that scenario, you lose the difference between the per share price you paid for the stock ($50) and the put option strike price ($45), minus the net credit premium ($1), multiplied by the number of shares (100) for a max loss of $4 per share ($400 total).
How to Trade an Options Collar
To trade a collar, an investor typically follows the following steps:
- Identify the underlying asset: The first step in trading a collar is to identify the underlying asset that the collar will be based on. This could be a stock, index, ETF, or other financial instrument.
- Determine the desired level of protection: The next step is to determine the desired level of protection against downside risk. This involves selecting a strike price for the put option that reflects the level at which the investor is comfortable limiting their potential losses.
- Select the expiration dates: The investor must also select the expiration dates for both the put and call options. The expiration dates should be chosen based on the investor’s trading goals and time horizon.
- Calculate the premium: The investor must calculate the premium that they will pay for the put option and the premium that they will receive for the call option. This will determine the net credit or debit of the collar.
- Enter the trade: Once the investor has determined the strike prices and expiration dates, and calculated the premiums, they can enter the trade by purchasing the put option and selling the call option. They will also need to purchase the underlying asset if they do not already own it.
- Monitor and adjust: Finally, the investor should monitor the performance of the collar and make any necessary adjustments based on changing market conditions. This could involve adjusting the strike prices or expiration dates of the options or closing out the trade entirely if market conditions change significantly.
Trading a collar requires careful consideration of the investor’s risk tolerance, trading goals, and market conditions.
How to Adjust an Options Collar
Adjusting a collar involves making changes to the positions of the call option, the put option, or both, in order to manage risk or lock in profits. Here are some common ways to adjust a collar:
- Rolling: This involves closing the existing collar position and opening a new one with different expiration dates or strike prices. Rolling can help to extend the time frame of the collar or adjust the position to reflect changing market conditions.
- Adding or removing options: This involves adding or removing options from the collar position to reflect changing market conditions.
- Closing: This involves selling the entire collar position. This can be done if the investor believes that the market conditions have changed to the point where the collar is no longer effective or if the investor simply wants to exit the position.
The choice of which adjustment to make will depend on the trader’s outlook on the stock price, risk tolerance, and other factors. It’s important to have a clear plan in place before entering into a collar trade, and to be prepared to adjust the position if necessary to manage risk and maximize profits.
Pros and Cons of Options Collars
Here are some potential advantages and disadvantages of collars in options trading:
- Protection against downside risk: The primary advantage of an options collar is that it provides protection against potential losses by combining the purchase of a put option with the sale of a call option.
- Locking in profits: Options collars can be used to lock in profits on an existing position with unrealized gains.
- Limited cost: In some cases, it is possible to create a zero-cost collar by selling a call option with a premium that covers the cost of purchasing the put option.
- Limiting potential gains: The sale of a call option to limit upside potential means that traders may miss out on potential gains if the price of the underlying asset rises above a certain level.
- Trading costs: There are costs associated with both buying the put option and selling the call option, which can reduce overall profits.
- Complexity: Collars can be complex to implement and manage, particularly for novice traders, and require a good understanding of options trading.
- Market volatility: In periods of high market volatility, the premiums for both the put and call options may increase, which can impact the overall cost-effectiveness of the collar strategy.
Overall, collars can be a useful tool for options traders looking to manage risk and balance potential gains and losses. However, as with any trading strategy, careful consideration of the pros and cons is necessary to determine whether it is appropriate for an individual’s investment goals and risk tolerance.
The Bottom Line
In conclusion, collars are a valuable tool for options traders looking to manage risk and balance potential gains and losses. By combining different options positions, collars can protect against potential downside while also allowing for some upside potential.
As with any investment strategy, it is important for traders to carefully consider their goals and risk tolerance before implementing collars or any other options trading strategy. Overall, collars can be a useful addition to an investor’s toolkit, but they should be used thoughtfully and in conjunction with other strategies to achieve a well-rounded portfolio.