Collars
January 2007
Most investors who come here want to use options to earn substantial profits. And that's great because option strategies are available to help you meet that goal. Other investors are more interested in usng options to help preserve their capital.
We've discussed covered call writing before - it's a conservative strategy suitable for investors who are first learning to use options. By selling call options, investors receive a cash premium that reduces the cost of owning the investment. I used this investment strategy myself for many years before moving on to more advanced strategies: some conservative, some more aggressive. This article is for more conservative investors.
Collars are not for everyone. But if you are more concerned about keeping what you already have - coupled with the chance of making some decent profits, then collars are for you.
A collar is a position with 2 parts. It consists of a covered call position (If you are unfamilar with covered call writing, see The Short Book on Options) and a long put option. Thus, if you own 100 shares of stock, sell one call option and buy one put option, you own a collar.
The collar derives it's name from the fact that a collar, or limit is placed on both the maximum and minimum value the position can attain. It's true that establishing a maximum limits your profit potential, but in return, it guarantees that your investment can never be worth less than a specified minimum. That's good tradeoff for many investors. If you owned stocks as the bubble burst, then you understand why some investors would be very happy to know that can never happen to them again. Once you own a collar, the value of your investment can never drop below a certain level. And that brings peace of mind.
Let's see how this works with an example:
Note: Option prices vary depending on several factors (stock's volatility, time remaining before options expire, dividends (if any), interest rates.)
- Buy 1,000 shares of XYZ @ 52; cost $52,000
- Sell 10 Sep 55 calls @ 0.85; collect $850
- Buy 10 Sep 50 puts @ 0.65; pay $650
- Net cash from option trades: $200
- Net position cost: $51,800
When expiration arrives, the maximum value of this position is $55,000. Why? Because if XYZ is trading above 55 per share, then the owner of the call option exercises his or her rights and buys your shares, paying the strike price, or $55. Maximum profit is $3,200.
That cap on profits may not be too appealing, but wait! Let's look at the reason for using the collar in the first place. When expiration arrives, if XYZ is trading below 50 you exercsie your rights as a put owner and sell your shares at the strike price, or $50. This is true, no matter if the stock is currently priced at 45, 40, or even lower. The most you can lose when holding this collar position is (in this example) $1,800.
If the stock is between 50 and 55 when expiration arrives in Sep, then both options expire worthless and you keep the $200 as extra profit from your posiiton. You are then free to reestablish another collar position for the Oct (or any other) expiration date.
Is this good for you? Are you willing to set a limit on potential profits in exchange for establishing a maximum possible loss? Collars do not suit every trader, but if preventing losses is at the top of your investment priority list, then collars may be for you.
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