A collar approach is a multi-leg options strategy that incorporates a long stock position with a protective put and a covered call. It concerns purchasing a stock, protecting against downside risk by purchasing a put option and funding the put purchase by selling a call option. The strategy is ideal for investors holding a long stock position and who want to limit their risk while accepting limited upside potential. The goal is to offset the cost of the long put with the premium received from the short call.
Strategy Mechanics
The collar strategy requires owning at least 100 shares of stock, combined with a covered call above the stock price and a protective put below the stock price. The put and call options should have the same expiration date and number of contracts, though the expiration date and strike price can be chosen by the investor. Traders use a collar strategy to protect against downward market movement. The long put protects against downside market movements, while the premium received from shorting the call helps finance the put purchase.
Risk and Reward
The collar strategy provides downside risk protection while limiting upside profit potential. It is a defensive strategy that limits potential losses while capping potential gains. The investor agrees to sell the stock at a predetermined price if it increases above the call option’s strike price. The overall effect is to create a range of more predictable investment outcomes bounded by the put and call positions’ strikes.
Conclusion
The collar strategy is a valuable risk management tool for investors seeking to protect their stock holdings from potential losses while still taking part in potential gains. It is a low-risk strategy suitable for investors who are conservatively bullish. By understanding the mechanics, risks, and rewards, investors can use the collar strategy to manage their portfolios effectively.
