- Min-Max Inventory Supply Chain Strategies
- The Collar Strategy
- Limited Profit Potential
- Limited Risk
- Breakeven Point(s)
- Limited Risk
- Similar Strategies
- The Costless Collar
- You May Also Like
- Continue Reading...
- Buying Straddles into Earnings
- Writing Puts to Purchase Stocks
- What are Binary Options and How to Trade Them?
- Investing in Growth Stocks using LEAPSÂ® options
- Effect of Dividends on Option Pricing
- Navigation menu
- Bull Call Spread: An Alternative to the Covered Call
- Dividend Capture using Covered Calls
- Leverage using Calls, Not Margin Calls
- Day Trading using Options
- What is the Put Call Ratio and How to Use It
- Understanding Put-Call Parity
- Understanding the Greeks
- The Important Underlying Price Points
- Valuing Common Stock using Discounted Cash Flow Analysis
Min-Max Inventory Supply Chain Strategies
Home / Option Strategy Finder / Bullish Trading Strategies
The Collar Strategy
A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding.
The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.
|Collar Strategy Construction|
|Long 100 Shares|
Sell 1 OTM Call
Buy 1 OTM Put
Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put.
The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.
Collar Strategy Payoff Diagram
Limited Profit Potential
The formula for calculating maximum profit is given below:
- Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
The formula for calculating maximum loss is given below:
- Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium Received + Commissions Paid
- Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.
- Breakeven Point = Purchase Price of Underlying + Net Premium Paid
Suppose an options trader is holding 100 shares of the stock XYZ currently trading at $48 in June.
He decides to establish a collar by writing a JUL 50 covered call for $2 while simultaneously purchases a JUL 45 put for $1.
Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but receives $200 for selling the call option, his total investment is $4700.
On expiration date, the stock had rallied by 5 points to $53.
Since the striking price of $50 for the call option is lower than the trading price of the stock, the call is assigned and the trader sells the shares for $5000, resulting in a $300 profit ($5000 minus $4700 original investment).
However, what happens should the stock price had gone down 5 points to $43 instead?
Let's take a look.
At $43, the call writer would have had incurred a paper loss of $500 for holding the 100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his shares for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500 minus $4700 original investment).
Had the stock price remain stable at $48 at expiration, he will still net a paper gain of $100 since he only paid a total of $4700 to acquire $4800 worth of stock.
Note: While we have covered the use of this strategy with reference to stock options, the collar strategy is equally applicable using ETF options, index options as well as options on futures.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run.
If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The beauty of using a collar strategy is that you know, right from the start, the potential losses and gains on a trade. While your returns are likely to be somewhat muted in an explosive bull market due to selling the call, on the flip side, should the stock heads south, you'll have the comfort of knowing you're protected.
The following strategies are similar to the collar strategy in that they are also bullish strategies that have limited profit potential and limited risk.
Costless Collar (Zero-Cost Collar)
Bull Put Spread
Bull Call Spread
The Costless Collar
If capital protection rather than premium collection is the main focus, a bullish investor can establish an alternative collar strategy known as the costless collar.
You May Also Like
Buying Straddles into Earnings
Buying straddles is a great way to play earnings.
Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
Writing Puts to Purchase Stocks
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
What are Binary Options and How to Trade Them?
Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[Read on...]
Investing in Growth Stocks using LEAPSÂ® options
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPSÂ® and why I consider them to be a great option for investing in the next MicrosoftÂ®....
Effect of Dividends on Option Pricing
Cash dividends issued by stocks have big impact on their option prices.
This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
Bull Call Spread: An Alternative to the Covered Call
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement.
In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Dividend Capture using Covered Calls
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
Leverage using Calls, Not Margin Calls
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk.
A most common way to do that is to buy stocks on margin....[Read on...]
Day Trading using Options
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading....
What is the Put Call Ratio and How to Use It
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Understanding Put-Call Parity
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969.
It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
Understanding the Greeks
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions.
The Important Underlying Price Points
They are known as "the greeks".... [Read on...]
Valuing Common Stock using Discounted Cash Flow Analysis
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]