Using Options to 'Collar' Stock Profits

The collar strategy is a slightly cheaper -- but riskier -- way to "insure" shares against a pullback, compared to a protective put

Sep 22, 2016 at 3:14 PM
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    Trading stocks and taking risks in the financial market is really all about achieving one goal: profits. Despite their reputation as "riskier" investments, options can often be used to hedge a trader's stock portfolio, and ensure that paper profits don't simply disintegrate after a stormy day. Strategies such as the protective put can help traders lock in gains and minimize losses for just the price of entry on an option trade. For traders who are looking for a slightly cheaper -- but riskier -- way to "insure" their shares against a pullback, the collar is one options strategy to consider.

    Collars are initiated by purchasing a protective put, and then simultaneously selling to open a covered call, which helps offset the cost of the hedge. For example, imagine that a trader owns shares of Stock XYZ. The stock is currently ascending into the $97 area, and the trader is concerned the shares will pull back at the round $100 level, as they've done in the past. Given that the trader originally purchased her 100 shares for $80 each, she would like to make sure she is able to preserve at least some of the profits she has reaped so far.

    To do this, she could buy to open a short-term 95-strike put at $2, or a total of $200 ($2 x 100 shares per contract). That in itself would be a protective put, and would guarantee the most the trader receive for her XYZ investment is $95 per share, no matter how far the stock should fall within the option's lifetime. Then, if XYZ continues its rally, the trader would be out $200, but would still own those surging shares.

    However, to lower the cost of entry on the hedge, she could simultaneously sell to open a 100-strike call for $1.50, or $150 ($1.50 x 100 shares per contract). This makes her total cost of entry only $50 ($200 - $150). However, this lowered cost of entry does come at the cost of a higher risk. 

    If XYZ suddenly drops, the trader can still exercise that protective put and sell her shares at $95 apiece -- a significant premium to the $80 purchase price. But, if the stock rallies above the call strike, the shares could be called away -- meaning the trader would miss out on additional upside north of $100. 

    In conclusion, the collar is a good strategy for traders who want to "insure" their shares at a discount, relative to simply buying a protective put. However, it's important to be very careful when choosing the strike price of the covered call, since they may end up parting with the shares. In addition, some traders are lucky enough to sell their covered call for a higher premium than the protective put, resulting in a net credit (that can be kept if both options expire worthless), but the collar is primarily a hedging strategy to give speculators peace of mind, rather than a way to generate revenue.

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