Stock Option Collar Strategy
The only reason to use the stock option collar strategy is as a hedge for an asset that you already own, but you do not want to sell for some reason (most likely because you do not want to pay taxes to Uncle Sam). For those of you who have been sold a bill of goods on Covered Calls, but found you get in trouble when your stock price goes south, we've got a better idea. Collaring your stocks with options may just be the solution you are looking for.
Stock Option Collar – There are two types of Collars, Protective and Appreciating. Both are used for stocks that you own, or want to own, for the long term.
Protective Collar – When you already own a stock and do not want or can not sell it, but you are Bearish on the company or the stock market in the short term you should consider this hedging strategy. Buy an ATM Put and Sell an ATM Call to pay for the Put. This isn’t really a trading strategy because you are not trying to make a profit, but is presented here for illustration purposes. The risk is the net debit, if any, calculated as the cost of the Put - credit received for sale of the Call. If you can make this trade with enough credit to cover your commissions, you have locked your stock price at the strike price of the options until they expire.
Appreciating Collar – When you want to own a stock for the long term, but you are Bearish on the company or the stock market in the short term you should consider this hedging strategy. Buy an ATM Put and Sell an OTM Call to help pay for the Put. This trade is most profitable when volatility is high and there is a skew between prices of Puts and Calls.
If you are a big fan of Covered Calls that is willing to accept some risk of the stock price falling, you could buy an OTM Put instead of an ATM Put so that you can keep some of the income generated by selling the OTM Call.
One important thing to notice about this trade is that its risk graph looks just like a Bull Call Spread. On a percentage basis the Bull Call Spread has a much higher profit potential than the Stock Option Collar.
Entry Rules
Bullish expectations for the underlying asset, but concern that overall market or news may cause short term drop in asset price.Most profitable when volatility is high and there is a skew between prices of Puts and Calls.
Exit Rules
Hold position until expiration
- Stock closes below Put strike price: Call expires worthless so you profit on the credit you received. Sell the Put for a profit to cover the loss on the stock, or exercise the Put to sell stock at the higher strike price.
- Stock closes above Call strike price: Put expires worthless. Stock is Called away by Call option that is now ITM.
- Stock closes between the strike price of the purchased Put and the Sold Call: Nothing to do. Calls and Puts expire worthless. Sell stock or create a new collar depending on your outlook.
Profit & Loss Calculations for the Stock Option Collar (When strike price of Put is same as the stock price)
Maximum Risk – Cost of Put- Credit received for Call. ($3 - $1 = $2)
Maximum Profit – Limited to difference in strike prices – net debit paid, if any. $55 - $50 - $2 = $3.
Breakeven – Current stock price (or strike price of Put) + net debit paid $50 + 2 = $52
For Example:
Buy 100 shares ABC stock at $50
Buy 1 ATM Put at $50 strike for $3
Sell 1 OTM Call at $55 strike for $1
Maximum Risk: $3 - $1 = $2
Maximum Profit: $55 - $50 - $2 = $3.
Breakeven: $50 + 2 = $52
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