Collar
Overview
If the Protective Put is like buying insurance for your stock, then the Collar is like getting that insurance at a discount by agreeing to cap your potential gains. It's the financial equivalent of telling yourself, "I won't get super rich on this stock, but I also won't get wiped out."
Here's the deal: you own shares of a stock, you buy a put option to protect your downside (just like in a protective put), but then you also sell a call option above the current price to help pay for that protection. The result? Your stock position is now "collared" between two prices – you've created both a floor and a ceiling for your investment.
Key Characteristics
- Market Outlook: "I like this stock, but I'm nervous about the market and willing to cap my upside for peace of mind"
- Risk: Limited to the gap between your current stock price and your put strike, plus any net cost of setting up the collar
- Profit Potential: Capped at the difference between your current stock price and your call strike, minus any net cost
- Breakeven Point: Your original stock purchase price plus any net cost of the options (or minus any net credit)
When to Use
The Collar might be your strategy of choice when:
- You're sitting on some nice gains in a stock position and want to protect them
- You're willing to trade unlimited upside potential for better downside protection
- You think protective puts are too expensive on their own
- The market feels uncertain or volatile (election season, Fed meetings, earnings season)
- You want to sleep better at night without selling your position
Real-World Example
Let's make this concrete with a real-world scenario. Say you own 100 shares of XYZ stock that you bought at $50, and it's now trading at $55.
- You're up $5 per share – nice! But you're worried about a potential market correction
- You buy a three-month put with a $50 strike price for $2 per share ($200 total) for downside protection
- To offset this cost, you sell a three-month call with a $60 strike for $1 per share ($100 total)
- Your net cost for this protection is just $1 per share ($100 total)
Now your position is "collared" between $50 and $60. If XYZ shoots up to $70, your shares will be called away at $60, giving you a profit of $9 per share ($10 from stock appreciation minus your $1 net option cost). If XYZ crashes to $40, your put limits your loss to $6 per share ($5 from the stock decline plus your $1 net option cost).
The sweet spot? If XYZ stays between $50 and $60, both options expire worthless, you keep your shares, and you're only out the $1 per share you paid for the collar.
The Good Stuff
- You get downside protection at a discount (or sometimes even for free)
- You know exactly what your maximum gain and loss could be – no surprises
- You can adjust the width of your "collar" to match your risk tolerance
- You can roll your options forward to maintain protection over time
- You get to keep collecting dividends on your stock while it's protected
The Not-So-Good Stuff
- You'll miss out if your stock goes on a tear beyond your call strike
- You're still exposed to some downside risk between your current price and put strike
- Options expire, so you need to actively manage and renew your collar
- If your stock gets called away, you might face unexpected tax consequences
- Trading multiple options means more commission costs
Playing It Smart
- Set your strike prices at levels that let you sleep at night – this is about your comfort zone
- Try for a "zero-cost collar" where the call premium completely pays for the put
- Don't wait until the last minute to roll your options – plan ahead before expiration
- Be aware of upcoming dividends – they increase the chance your short call gets assigned early
- For longer-term protection, consider using LEAPS options to reduce the frequency of adjustments
- Remember that collars work best when you've already got some gains in your stock position