What Is An Options Collar?
The collar option strategy is a popular setup that investors use to protect their stock holdings from potential downside risks while generating income. It involves combining the purchase of a protective put option as a hedge with the sale of a covered call option, creating a “collar” around the stock position.
In this strategy, investors already own the underlying stock and are concerned about potential price declines. By purchasing a put option, they acquire the right to sell their shares at a specified price, known as the strike price, before or on the option contract’s expiration date. This put option acts as insurance, providing protection against significant losses if the stock’s value drops below the strike price.
On the other hand, investors also sell a covered call option against their stock position. A covered call involves selling someone else (usually another investor) the right to buy their shares at a specific strike price within a certain timeframe. By doing so, investors generate income from selling this call option premium.
The concept behind an options collar is that both options have similar expiration dates and are typically out-of-the-money when initially established. This means that both strike prices are set above or below (depending on whether it’s for puts or calls) the current market value of the underlying stock. As such, these options are less expensive than at-the-money or in-the-money options.
Buying protective puts and selling covered calls helps offset some of the costs associated with buying put options while providing limited protection against downside risk. The income generated from selling call options can partially or fully cover these costs.
The Purpose Of Using An Options Collar Strategy
The primary purpose of using an options collar strategy is to limit potential losses while still participating in the upside potential of a stock.
The options collar strategy involves combining three different positions: owning the underlying stock, selling a call option, and purchasing a put option. This combination creates a protective “collar” around the stock’s price movement, hence its name. The call option sold generates income that helps offset the cost of purchasing the put option.
The primary goal of implementing an options collar strategy is to protect against downside risk. By owning the underlying stock and purchasing a put option, investors have insurance against significant price declines. If the stock price were to plummet, the put option would increase in value, offsetting any losses incurred on the stock position.
However, using an options collar does not come without trade-offs. While it effectively limits potential losses on the downside, it also caps any gains on the upside due to selling a call option. This means that if the stock price rises substantially beyond the strike price of the call option sold, the investor will not realize any additional gains.
Nevertheless, utilizing an options collar strategy can benefit investors who prioritize capital preservation and are willing to sacrifice some upside potential for downside protection. It provides peace of mind by reducing overall portfolio volatility and offering insurance against adverse market movements.
Understanding The Components Of An Options Collar
Firstly, the long stock position is the cornerstone of an options collar. It represents the investor’s ownership of a particular stock or security. By holding this position, investors benefit from any potential upside in the underlying asset. The primary purpose of including long stock in an options collar is to ensure that investors continue to profit if the underlying asset price rises.
Secondly, the long put option is insurance for the investor’s stock position. This component protects against a decline in the price of the underlying asset. By purchasing a put option, investors have the right to sell their shares at a predetermined strike price within a specified period. This ensures that even if the market experiences a significant downturn, investors can still sell their shares at an agreed-upon price.
Lastly, short call options generate income for investors who implement an options collar strategy. Investors receive premiums upfront by selling call options on their existing stock holdings. These premiums act as compensation for granting someone else (the buyer of the call option) the right to purchase their shares at a predetermined strike price within a specified time frame.
When all these components are combined effectively, they create an options collar strategy that offers investors both protection and income generation opportunities. It allows them to mitigate downside risks while participating in any potential upside movements in their stock holdings.
How To Set Up An Options Collar Trade
Setting up an options collar trade involves a series of strategic steps that can help protect the value of your stock position while allowing for potential upside gains. The process requires careful consideration and analysis, but it can be an effective risk management technique when executed correctly. Here’s a step-by-step guide on how to set up an options collar trade.
1. Identify the stock: Begin by selecting the stock you wish to collar. It is crucial to choose a stock that you currently own or plan to acquire, as this strategy involves holding the underlying asset.
2. Determine the desired expiration date: Decide on the timeframe for which you want the options collar trade to be active. This will depend on your investment goals and market outlook.
3. Buy protective put options: Purchase out-of-the-money put options with a strike price below the current market value of your stock. These puts act as insurance against potential downside risks.
4. Sell covered call options: Simultaneously, sell out-of-the-money call options with a strike price above your stock’s current market value. By doing so, you generate income from premiums received while capping potential upside gains.
5. Calculate cost basis adjustment: Evaluate the net premium received from selling the call option against the cost of purchasing protective puts. This adjustment helps determine if there is any additional cost involved in setting up the collar trade.
6. Monitor and manage: Keep a close eye on your position throughout its lifespan, making adjustments as necessary based on changes in market conditions or personal investment objectives.
Advantages And Disadvantages Of Using An Options Collar Strategy
The options collar strategy is a popular approach used by investors to protect their stock positions from potential downside risks while still allowing for some upside potential. This strategy involves buying a put option and selling a call option on the same stock, typically with the same expiration date. While the options collar can be an effective risk management tool, it is important to consider both its advantages and disadvantages before implementing it.
One of the key advantages of using an options collar strategy is its ability to limit losses in a stock position. By purchasing a put option, investors have the right to sell their shares at a predetermined price, known as the strike price, regardless of how much the stock’s value may decline. This provides downside protection and helps mitigate potential losses during market downturns or unforeseen events.
Additionally, selling a call option generates income for investors. The premium received from selling the call option can partially offset the cost of purchasing the put option or even provide additional income. This can be particularly beneficial for those who want to protect their investment but also want to generate some cash flow from their holdings. However, there are also disadvantages associated with using an options collar strategy.
One major drawback is that it limits potential gains in a stock position. When investors sell a call option as part of the collar strategy, they give up any profits above the strike price if the stock rises significantly. Therefore, while this strategy protects against downside risk, it also caps potential upside returns. Another disadvantage is that implementing an options collar can involve transaction costs such as commissions and bid-ask spreads when entering or exiting positions.
These costs should be carefully considered as they can impact overall profitability. In summary, utilizing an options collar strategy provides investors with downside protection while generating income through selling call options. However, this approach also limits potential gains in exchange for reducing risk exposure.
Real-Life Examples Of Options Collar Trades
As stated earlier, there are three distinct steps in using the collar strategy. First is buying or owning 100 shares of the stock, or at least multiples of 100 shares for every contract the trader wants to protect. Next is buying the put that protects the asset from sudden price drops. At the same time, the trader writes a call for every contract, setting the strike price at an acceptable profit level. Let’s look at how the strategy plays out in a real-life trade.
Today, we’re studying Oracle Corporation (ORCL). A quick look at Barchart.com indicates that ORCL recently saw a significant price drop (with a full gap-down) and is now trading at $112.21.
Now, let’s look at what Option Samurai tells us about the possible collar strategy for Oracle.
Let’s assume the trader already owns 100 ORCL shares purchased for $112.21, so we can skip step one. The next step is to buy a protective put. Option Samurai suggests buying an out-of-the-money put contract with a $105 strike price for a premium of $1.51 to $1.54 that expires on November 11, a comfortable two months away from the time of the scan. The trader shells out $151 to $154, multiplied by the number of contracts bought if more than one.
The next step is to sell an in-the-money covered call with a $110 strike price for a $5.75 to $5.85 premium that expires on the same day as the put option. Selling an in-the-money call option now means more premium received, and the longer expiration date offsets the risk of assignment.
So, then, the trader receives $575 to $585 for the option, and the collar is established. Now, let’s break down the possible scenarios.
Breakeven
Assuming that the trader could buy the put for $1.54 and sell the call at $5.75, the breakeven price will be $108, as indicated with a dotted line in the PL profile. The computation goes like this:
Premium Received ($5.75 x 100 shares) – Premium Paid ($1.54 x 100shares )
$575 – $154 = $421 Net Premium Received
($112.21 Purchase Price – $108 Breakeven Price) x 100 shares = $421 Unrealized Losses
$421 Unrealized Losses = $421 Net Premium Received
At this price level at expiration, both the call and put option expires worthless, and the paper loss incurred from the price drop is equal to the net premium received.
Profit
In this scenario, the put expires worthless. Meanwhile, as long as the asset price stays below the short call’s strike price and the option expires worthless, the trader can continue to collect the premium minus what they’re paying for the protective put, which, in our example, is $421.
If ORCL’s price spikes beyond the short call’s strike price ($110), the buyer will likely exercise, and the option gets assigned. In this case, the trader actually loses out on the trade since they purchased the stock for $112.21 per share. The gross loss is calculated as $110 – $112.21 = -$2.21 x 100 shares = -$221.
But, again, the trader has $421 in the bag already. So that makes the total profit $421 – $221 = $200 for when the call option is exercised, as is indicated in the PL Profile.
Loss
The loss scenario for the collar strategy is realized when the price drops below the long put’s strike price of $105. Assuming that the trader exercises the long put to protect them from further price deterioration, the calculations for losses are as follows:
$105 Long Put Strike Price – $112.21 Purchase Price = -$7.21 x 100 = -$721 Gross Loss
$421 Net Premium Received – $721 Gross Loss = $300 Net Loss
That $300 represents the maximum loss for the whole trade. So, even if the price of ORCL drops to $100, $95, or even $80 before expiration, the trader is protected from further losses. However, it is important to remember that the protection is only active if the long put hasn’t expired yet.
Common Mistakes To Avoid When Implementing An Options Collar Strategy
Implementing an options collar strategy can protect your investments from potential downside risks while allowing for some upside potential. However, it is essential to be aware of the common mistakes investors often make when implementing this strategy. By avoiding these mistakes, you can maximize the benefits of your options collar and minimize any potential drawbacks.
One common mistake is not correctly assessing the risk profile of the underlying stock or portfolio. Before implementing an options collar, it is crucial to analyze the risk associated with the investment thoroughly. This includes understanding the volatility of the stock, its correlation with other assets in your portfolio, and any upcoming events or news that may impact its price. Failing to do so could result in choosing inappropriate strike prices for your options or misjudging when to implement the collar.
Another mistake is neglecting to regularly monitor and adjust your options collar as market conditions change. The effectiveness of an options collar relies on maintaining a balanced position between long stock, long puts, and short calls. Suppose market conditions shift significantly, such as a substantial increase in volatility or a change in outlook for the underlying stock. Adjustments may need to be made to rebalance your position.
Furthermore, some investors make the mistake of relying solely on historical data or technical indicators when implementing an options collar strategy. While these tools can provide valuable insights, they should not be used as a sole basis for decision-making. It is essential to consider current market conditions and fundamental analysis alongside historical data to make informed decisions. Lastly, emotional decision-making can often lead investors astray when implementing an options collar strategy.
Fear or greed may cause investors to deviate from their original plan at critical moments, potentially resulting in missed opportunities or increased risk exposure.
Strategies For Adjusting Or Exiting An Options Collar Trade
When implementing an options collar trade, it is important to have a plan in place for adjusting or exiting the trade if market conditions change. Here are some strategies that can be employed to manage your options collar effectively:
1. Adjusting the strike prices: One way to adjust an options collar trade is by modifying the strike prices of the options involved. If you anticipate a significant move in the underlying stock’s price, consider adjusting the strike prices of both the call and put options to capture potential gains or protect against losses.
2. Rolling up or down: Another strategy is rolling up or down your call and put options to lock in profits or minimize losses. If the stock price has risen above your call option’s strike price, consider rolling up your call option to a higher strike price, allowing you to participate in further upside potential. Conversely, if the stock price has fallen below your put option’s strike price, rolling down your put option can help limit potential losses.
3. Exiting individual legs: In certain situations, it may be beneficial to exit one leg of the options collar trade while keeping the other leg intact. For example, if you believe the stock will continue its upward trend, you might close out your put option position while maintaining your call option position.
4. Closing out both legs: If market conditions have significantly changed and no longer align with your original trading thesis, closing out both legs of the options collar trade may be appropriate. This allows you to exit the trade entirely and reassess new trading opportunities.
5. Time-based adjustments: As time passes and expiration approaches, adjustments may need to be made based on changes in implied volatility or other factors affecting pricing dynamics. Remember that each adjustment strategy carries its own risks and rewards.
Conclusion: Is The Options Collar Strategy Right For You?
After understanding the intricacies of the options collar strategy, it is crucial to determine whether this approach aligns with your investment goals and risk appetite. While the options collar can effectively protect your portfolio from potential downside risks, it may not be suitable for every investor.
One of the primary advantages of employing the options collar strategy is its ability to limit losses while allowing for potential gains. By combining a protective put option with a covered call, investors can create a cushion against market downturns while generating income from their existing holdings. This approach provides security and peace of mind during volatile market conditions.
However, it is essential to consider some limitations and factors before implementing this strategy. Firstly, the cost associated with purchasing protective put options can reduce potential profits and increase transaction costs. Additionally, if you expect significant price appreciation in your underlying asset, selling covered calls may restrict your upside potential.
Furthermore, successfully implementing an options collar requires careful monitoring and active management. Regularly evaluating market conditions and adjusting your positions is crucial to ensure your portfolio remains adequately protected.
Investors who are risk-averse or have a long-term investment horizon may find the options collar strategy appealing due to its focus on capital preservation rather than aggressive growth. On the other hand, those seeking higher returns or willing to take on more risk might prefer alternative strategies that offer greater profit potential.
Ultimately, determining whether the options collar strategy is right for you depends on various factors such as your investment objectives, risk tolerance, and time commitment. It is advisable to consult with a financial advisor who can help assess your specific circumstances before incorporating this approach into your investment portfolio.