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Visually Analyze Option Strategies
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Collar

 

Description

A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put and the call are both out-of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.

P/L Profile
Description: Description: http://www.avasaram.com/images/strategies/PLSP/Collar.png
Market Opinion
Neutral, following a period of appreciation

When to Use

An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock.

Benefit

This strategy offers the stock protection of a put. However, in return for accepting a limited upside profit potential on his underlying shares (to the call's strike price), the investor writes a call contract. Because the premium received from writing the call can offset the cost of the put, the investor is obtaining downside put protection at a smaller net cost than the cost of the put alone. In some cases, depending on the strike prices and the expiration month chosen, the premium received from writing the call will be more than the cost of the put. In other words, the combination can sometimes be established for a net credit - the investor receives cash for establishing the position. The investor keeps the cash credit, regardless of the price of the underlying stock when the options expire. Until the investor either exercises his put and sells the underlying stock, or is assigned an exercise notice on the written call and is obligated to sell his stock, all rights of stock ownership are retained.

Risk vs. Reward

This example assumes an accrued profit from the investor's underlying shares at the time the call and put positions are established, and that this unrealized profit is being protected on the downside by the long put. Therefore, discussion of maximum loss does not apply. Rather, in evaluating profit and/or loss below, bear in mind the underlying stock's purchase price (or cost basis). Compare that to the net price received at expiration on the downside from exercising the put and selling the underlying shares, or the net sale price of the stock on the upside if assigned on the written call option. This example also assumes that when the combined position is established, both the written call and purchased put are out-of-the-money.

Net Upside Stock Sale Price if Assigned on the Written Call:

Call's Strike Price + Net Credit Received for Combination

or

Call's Strike Price - Net Debit Paid for Combination

Net Downside Stock Sale Price if Exercising the Long Put:

Put's Strike Price + Net Credit Received for Combination

or

Put's Strike Price - Net Debit Paid for Combination

If the underlying stock price is between the strike prices of the call and put when the options expire, both options will generally expire with no value. In this case, the investor will lose the entire net premium paid when establishing the combination, or keep the entire net cash credit received when establishing the combination. Balance either result with the underlying stock profits accrued when the spread was established.

Break-Even-Point (BEP)

In this example, the investor is protecting his accrued profits from the underlying stock with a sale price for the shares guaranteed at the long put's strike price. In this case, consideration of BEP does not apply.

Volatility
If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay
Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes.

Alternatives before expiration

The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace.

Alternatives at expiration

If the underlying stock price is between the put and call strike prices when the options expire, the options will generally expire with no value. The investor will retain ownership of the underlying shares and can either sell them or hedge them again with new option contracts. If the stock price is below the put's strike price as the options expire, the put will be in-the-money and have value. The investor can elect to either sell the put before the close of the market on the option's last trading day and receive cash, or exercise the put and sell the underlying shares at the put's strike price. Alternatively, if the stock price is above the call's strike price as the options expire, the short call will be in-the-money and the investor can expect assignment to sell the underlying shares at the strike price. Or, if retaining ownership of the shares is now desired, the investor can close out the short call position by purchasing a call with the same contract terms before the close of trading.

Example

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

 

 
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