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Collar Strategy

Tony Zhang
December 6, 2021
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10 minutes read
Collar Strategy

The Collar strategy is a strategy that allows investors to protect from large downside losses on a stock. This strategy requires the investor to have a minimum of 100 shares of the stock. The Collar strategy can also be considered as a combination of two strategies – writing a Covered Call and buying a Put option.

Collars work best for scenarios where the investor is long the stock but is uncertain about the short-term prospects. It also works best when the investor has substantial unrealized gains on the long stock position as the stock may be called away due to the Covered Call leg of the strategy and will result in a net profit on the capital appreciation of the stock if the cost basis of the shares is below the strike of the Covered Call. The Collar strategy protects against declines in the stock but also restricts the upside.

The Covered Call Leg

The prerequisite for this strategy is for the investor to own 100 shares of the stock. The first step in utilizing the Collar strategy is to write a Covered Call. The Covered Call should be “out of the money” and the strike price can vary depending on the risk of assignment the investor is willing to take. Strike prices that are close to the underlying’s price will provide more premium, but there is a higher probability of that strike price being reached and getting assigned to sell the shares at the strike price. Strike Prices further away from the underlying will offer less premium, but more breathing room for the stock to appreciate without being called away.

The Put Leg

By purchasing an “out of the money” put option, the investor will be able to limit the downside of the stock as the put option will appreciate in value should the value of the shares decline. Like the Covered Call leg of the strategy, the strike price should be based on the drawdown the investor is comfortable with before requiring protection. For example, if the stock is trading at $100, and the investor is willing to accept a 10% drawdown in the stock, the strike price of the put should be at $90. Should the stock decline below $90, the put option becomes “in the money” and will appreciate in value should the stock continue to decline further.

Implementing the Collar Strategy

The Collar strategy requires 3 steps – owning 100 shares of the stock, selling a Covered Call, and buying a Put option, as mentioned above. Strike selection is key for this strategy to be effective. The strike price of the Covered Call should be above the current price of the underlying and the strike price of the Put option should below the current price of the underlying. While the amount that the options are “out of the money” is based on the investors risk tolerance, the two strikes should be equidistant from the underlying price. This will allow the premium received from selling the Covered Call to effectively cancel out the premium paid to buy the Put option. In other words, the investor will be able to use the Put option to hedge against the stock decline for a much lower price when compared to simply buying a Protective Put as a hedge. The downside to this is the risk of assignment should the stock rally above the Covered Call strike price.

Example

Consider the example where an investor has purchased 100 shares of $BMO at $100. The shares are now trading at $110. The investor is concerned of upcoming market volatility and wants to hedge the position by using a Collar:

  • Sell 1 $120 Covered Call @ $2.80 Credit
  • Buy 1 $100 Put @ $3.00 Debit
  • Net debit paid = $0.20 (per share)

The investor has effectively opened a very cheap hedge on $BMO should it decline below $100. Simply buying the $100 put without selling the Covered Call would have resulted in the investor paying $3.00 per share compared to the $0.20 the investor is paying now. The breakeven for this strategy is the sum of the cost basis of the stock purchase and the net premium paid (or received) from selling the Covered Calls and Buying the Put. In this case, the investor paid $0.20 per share for the Collar. The breakeven price is therefore $100 + $0.20 = $100.20. If the stock remains above this price, the trader is still in a profitable position.

The maximum P&L is calculated as follows:

  • Max profit = (Call Strike +/- premium paid/received) – stock purchase price:
  • ($120 – $0.20) – $110 = $9.80 per share.
  • The reason that the $0.20 is subtracted from $120 is because it was paid to open the Collar. If the net premium were a Credit, it would be added to the $120. The max profit is reached should the stock rally to the Covered Call strike or above.
  • Max loss = Stock purchase price – (Put Strike +/- premium paid/received):
  • $110 – ($100 – $0.20) = $10.20 per share.
  • The reason that the $0.20 is subtracted from $100 is because it was paid to open the Collar. If the net premium were a Credit, it would be added to the $100. The max loss is reached should the stock decline to the Put strike or below.

 

This strategy allows investors to effectively hedge their long stock position for a lower cost than simply buying a Put option. What is important to remember here is that motivation for this strategy is when the investor believes that the stock is vulnerable to a decline. The Collar strategy is an effective hedging method as the Covered Call essentially pays for the Put option and the investor will be protected from significant declines in the stock. However, by selling a Covered Call, the shares may be called away should the stock rally instead. This is why the Collar strategy should only be used on stock holdings that already have a significant unrealized profit as the investor will still profit on the capital appreciation of the stock in the event that it is called away.

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Montreal Exchange’s prior written consent.  This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.  This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice.  The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange.  TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Toronto Stock Exchange, TSX, TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.  Montreal Exchange and MX are the trademarks of Bourse de Montréal Inc.  All other trademarks used herein are the property of their respective owners.

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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