A collar is viewed as a spread strategy designed to protect unrealised profits on stock you already own. You purchase a protective put on your long stock position, and offset the cost of that put by writing a call that is covered by your long stock position.
The collar spread is also known as a fence for the protection it provides. In most cases, both the long put and the short call are out-of-the-money. If the call you write is less expensive than the put you buy, you’ll pay more premium than you receive, and will establish a debit collar. If the put you buy is less expensive than the call you write, you’ll receive more premium than you pay, and will establish a credit collar.
A collar might be used as a protective strategy. For example, if you hold a stock that has made significant gains, you might want to lock in those gains, protecting your position against a future drop in price. Writing a covered call may fully or partially offset the cost of purchasing a protective put. Just as with other spread strategies, the collar is aimed to reduce the risk and increase the chances of the potential profit. For example, say you purchased 100 shares of LMN at $15 two years ago, and its current market price is $30.
100 Shares x $15 per Share = $150 Original Cost
If you purchase a 25 put, you’ll have the right to sell those shares at $25 before expiration, locking in a $10 profit on each share, or a total of $1,000. Suppose that put costs you $275, or $2.75 per share. Let’s say you also write a 35 call with the same expiration month, and receive $250 in premium, or $2.50 per share.
$275 Put Price Paid - $250 Call Price Received = $25 Net Cost
If the price of LMN rises above $35 at expiration, your call most likely will be exercised. You’ll receive $3,500 for your shares, or a $2,000 profit, but you’ll miss out on any further gains the stock may have. Since the put you purchased cost more than the call you wrote, your net cost is $25 — less than one tenth of the price of the protective put alone. It would cost you only $25 to ensure that you could sell at a minimum profit of $10 per share, or $1,000 per contract. A collar may work particularly well if you have a neutral to bearish market forecast for a stock that has behaved bullishly in the past, leaving you with unrealised gains you’d like to protect. Some investors use collars as income-producing strategies by selling them for a credit. While that approach may be profitable, it also requires time and attention to manage the strategy.
RULE OF THUMB: Call and put options move in opposition. Call options usually rise in value as the underlying market prices go up. Put options usually rise in value as the market prices go down—but time decay and a change in volatility also have an effect.
Commissions and Fees
As with stock transactions, options trades incur commissions and fees charged by your broker to cover the cost of executing a trade. You’ll pay fees when opening a position as well as when exiting. The amount of these charges varies from broker to broker, so you should check with yours before executing any transaction. Be sure to account for fees when calculating the potential profit and loss you face. You should also keep in mind that spread transactions that require two legs mean you may face double commissions at entry. And it also helps to consider that any strategy that ends with an unexercised option, such as a covered call, means—if you’re not assigned—you won’t pay any commissions or fees at exit.
Your Options at Expiration
Depending on the direction the stock moves, your choices at expiration of the legs of your collar vary:
If the price of the stock rises above the strike price of the short call: If assigned, you can fulfil your short call obligation and sell your shares at the strike price. You’ll lock in profits over what you initially paid for the stock, but you’ll miss out on any gains above the strike price.
Alternately, you could close out your position by purchasing the same call you sold, quite possibly at a higher price than what you paid for it. This may be worth it
if the difference in premiums is less than the additional profit you anticipate you’ll realize from gains in the stock’s value, or if one of your goals is to retain the stock.
If the price of the stock remains between both strikes: You can let your put expire unexercised, or sell it back, most likely for less than what you paid, since its premium will have decreased from time decay. Your short call will probably expire unexercised, which means you keep the entire premium. Depending on whether your collar was a credit or debit spread, you’ll retain your initial credit as a profit, or debit as a loss.
If the price of the stock falls below the strike price of the long put: By exercising your put, you can sell your shares at the strike price. Your short call will probably expire unexercised, and you keep all of the proceeds from the sale of the call.
When executing a collar, it’s important to define your range of return, or the strike prices for both the put you purchase and the call you write. The strike price of the protective put should be high enough to lock in most of your unrealized profit. The strike price of the covered call should be high enough to allow you to participate in some upward price movement, but not so far out-of-the-money that the premium you receive does little to offset the cost of your protective put.
Source: The Options Industry Council
otherwise known as OIC.