Hedging: Protective Puts vs. Collars

When you're looking to hedge against potential losses in a long stock position, you have a couple of alternatives. First, and perhaps most common, is the protective put. In this strategy, you buy long put options against your shares, which guarantee you a minimum exit price on the position (no matter how far the stock falls prior to expiration). Next we have the collar, which combines a protective put with a covered call. So, which strategy should you use to hedge?

Protective Put

The protective (or "married") put is a good, solid, utilitarian choice for most of your hedging needs. Whenever you'd like to limit the downside risk on a stock holding -- or even lock in some paper profits -- simply purchase one put option per 100 shares, aligning the strike price with your preferred minimum exit price on the shares. That way, if the stock falls below the strike before the options expire, you can exercise the option and unload the investment at your predetermined price.

The primary downside to buying a protective put is that you might not need it. If the stock holds steady or rises, your option will expire worthless, and you'll forfeit the entire premium paid. Of course, since you're buying protective puts as a shareholder, continued strength in the stock can't really be viewed as a "negative" development.

Collar

Likewise, a collar offers insurance against a downside move in the stock, since it's partially comprised of a protective put. However, in this strategy, the presence of a covered call means you've also established an upside exit price on the shares. If the stock rises above the strike price of the sold call prior to expiration, you may be assigned. With this in mind, the collar is best suited for stocks you wouldn't mind parting with once they've reached a specific target price (which, ideally, should align with the strike of your sold call).

While the prospect of saying goodbye to the shares is a potential con, the big pro to playing a collar is the reduced cost of entry relative to a lone protective put. With a collar, the premium you receive from selling the call helps to offset the price paid to buy the put. As a result, it's somewhat less expensive to hedge with a collar than a solo protective put.

Which Way to Hedge?

If you'd be heartbroken to lose a particular stock from your portfolio, it's probably best to play a protective put. That way, there's no risk of having the shares called away if they rally. On the other hand, if you wouldn't mind unloading your stake at the right price, a collar offers an economical method to limit your losses.