Collar Options Strategy

A collar option strategy, or simply collar, is a trading strategy that involves buying a protective put option to limit downside risk and selling a covered call option to generate income. The idea is to "collar" the value of an underlying asset within a certain range so that the investor can protect against large losses while still participating in potential gains.

The collar option strategy can be useful for investors who want to protect their portfolios against potential losses while still engaging in potential gains. By using a combination of buying a put option to limit downside risk and selling a call option to generate income, the collar can help reduce the cost of hedging and limit losses in the event of a market downturn.

• A collar options strategy is a risk management strategy used by investors to protect their portfolios against potential losses while still generating income.
• This strategy involves buying a protective put option to limit downside risk and selling a covered call option to generate additional income.
• The protective put option serves as an insurance policy against potential market downturns. In contrast, the covered call option generates income by allowing another investor to buy the underlying asset at a fixed price.
• The collar options strategy suits investors willing to sacrifice potential gains to limit their downside risk and generate additional income.

The collar option strategy is a common method of hedging that can be useful for investors looking to protect against potential losses while still participating in potential gains. It involves an investor holding a long position on an underlying asset, which means they will profit only if the asset's price increases. However, this also exposes them to unlimited loss if the price falls.

To protect against this risk, the investor can hold a long position in an out-of-the-money put option, known as a protective put, which is set at a specific price referred to as the floor price. This protects the investor from losses up to the floor price, even if the asset's price falls below that level. However, the investor must pay a premium for this protection.

To offset the premium cost, the investor can take a short position in an out-of-the-money call option, known as a covered call, which generates income via premium. Furthermore, the covered call would limit the investor's gains if the asset's price were to cross the strike price, as the investor would only reap gains up to that point while exceeding gains would belong to someone else.

The collar option strategy limits positive and negative returns, making the payoff relatively flat. The investor's returns will range from the strike prices of the call and put options. If the asset's price exceeds the call option's strike price, the gains from the asset appreciation will be offset by the loss from the call option above its strike price. Similarly, if the asset's price falls below the put option's strike price, the profits from the put option will cancel the losses from stock depreciation.

Refer to the examples of collar options given for more clarity.

Example #1

Study the information below to understand how a long-collar options strategy works. Ian holds a long position, an asset currently at $200. He is confident about the asset in the long run but not short-term gains. So, Ian buys a put option with a $175 strike price at a $10 premium. Further, he sells a call option for $10 at a strike price of $220. A week later, the asset price appreciated to $215.

Due to the asset appreciation, Ian will lose $10 from the put option while gaining $10 from the call option. This is neutralization. However, this will be his net gain since the price has increased by $15.

Example #2

Here's news from March 2022, when a single covered and protective collar options strategy from a JPMorgan fund sent tremors to the United States stock market. The trade occurred on March 31, 2022, at around 11:00 am and involved selling and purchasing 44,000 June call and put options.

The Russia-Ukraine war seems like a possible reason for the unanticipated massive trade. Some analysts suspect the 1.56% drop in the S&P 500 by the end of the day can be attributed to the trade that might have exacerbated market weakness and volatility.

Payoff diagrams are a common tool used in options trading. Here, the asset price (X-axis) is plotted against profit/ loss (on Y-axis). Before understanding the payoff diagram of a collar strategy, let's see the graph of a simple options payoff with no additions.

In graph 1, the regions of unlimited loss and gain are clear. At the break-even point, there is no loss or gain. The investor will lose if the asset price falls below the spot price. The degree of loss depends on to what extent the price will fall. If the asset price rises, the investor will make profits, depending on the extent of the increase.

Now, after the protective put, the decrease in loss can be noticed by the reduction in the shaded area (in graph 2). Similarly, the covered call has caused a decrease in profit. Now, the investor's returns can lie anywhere in the shaded regions. Therefore, the maximum loss the investor will make corresponds to the SP (Put) or the strike price of the put option, and the maximum profit the investor will make corresponds to the SP (Call) or the call option strike price.

let's look into some of the advantages and disadvantages of the collar options strategy:

Advantages

• The collar is a prominent method used to hedge risk. Thus, it can be very helpful if the investment amount is significant. In addition, since the stock market is prone to volatility and sudden disruptions, such a mechanism of offsetting losses can be necessary.
• Buying a put option alone is another hedging strategy, but a smart investor must account for the purchase cost. This can be done by selling a call option, as seen in a collar.
• Another important benefit is that the investor owns the underlying asset, making them eligible for dividend payments and the rights that come with it.

Disadvantages

• The most important factor that makes the collar a less appealing strategy to investors is its profit-limiting nature. Here, the investors enter a trade-off – fewer gains for less loss.
• Additionally, the gains might be someone else's if the price keeps increasing beyond the call option strike price.
• Also, the strategy is a complicated one to understand and implement.

This article has been a guide to what is Collar Options Strategy. We explain it in detail with its examples, payoff diagram, advantages, and disadvantages. You may also find some useful articles here -

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