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The collar strategy may be the ultimate “fail-safe” of the options world, offering a known upside should the underlying move higher, a little less should it stay put, and a modest loss should the stock move lower.
It’s comprised of three separate components:
- 100 shares of the underlying security;
- The sale of one out-of-the-money call option; and
- The purchase of an out-of-the-money put option.
In effect, it’s a covered call with a put purchase thrown in for insurance.
When Is It Employed?
As mentioned, traders might consider using a collar if they already have a covered call in place and are worried about some near-term downside. Or, they might set the trade when they hold 100 shares of the underlying and have no clue at all what to expect over the near term. In such a scenario, the collar provides a reasonable expectation of emerging with something.
Let’s now look at a genuine example to get a better feel for the profit/loss profile of the trade, as well as its break-evens.
Below is a chart of the Consumer Staples Select Sector SPDR ETF (NYSEArca: XLP) during a period of extended indecision:
You own shares of XLP and regularly write calls against them, but after a nice burst higher in October, your stock is called away. You’re unsure what might come next, but would like to continue with the covered call program, as it’s yielded tremendous benefits to date. Your broker, too, is wary of the stock’s next move, so together you decide to turn the trade into a collar.
In early November, with the stock at exactly $50 (red circle), you buy another 100 shares, sell one February 52 call for $4 and buy the February 47 put for $3. Your total debit for the trade is $4,900 ([$50 – $4 + $3]) x 100), including the credit from the options.
The Zigzag Ensues
For the next three months XLP trades in a band between $47.50 and $51.50 and no one is certain which way it will break. But by the time February’s expiry arrives, the stock settles at exactly $51. Both options expire worthless, but you remain up $100 from the initial credit and are ready to reinstate the covered call position with a more bullish outlook.
But what if things had gone awry? What if the stock had settled lower, say, at $40?
Well, the short call would have expired worthless, the shares would be underwater $9 each (including the initial credit) and the long put would be worth $7. Your loss would be precisely $200 – the maximum possible risk for the trade.
On the other hand, had the shares risen through the short call strike at $52, the long put would have withered to nothing, the shares would have been called away at $52 and your profit would have been $300 ([$52 – $49] x 100), the maximum take for the trade.
Break-even for the collar is the purchase price of the shares less any premium taken. In the above example, the break-even point is $49.
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