Define Collar

Collar

What Is a Collar, Exactly?

A collar, also known as a hedge wrapper or risk-reversal, is an options strategy used to limit huge profits while protecting against significant losses.

By buying an out-of-the-money put option and concurrently writing an out-of-the-money call option, an investor who is already long the underlying establishes a collar. The put hedge protects the trader if the stock price falls. Writing the call generates money (which should more than cover the cost of buying the put) and allows the trader to profit on the stock up to the call's strike price, but not higher.

TAKEAWAYS IMPORTANT

• A collar is an option strategy that combines purchasing a downside put and selling an upside call to protect against severe losses while also limiting huge profits.

• A protected put and a covered call are two tactics used in the protective collar approach.

• The best-case scenario for an investor is when the underlying stock price at expiry is equal to the strike price of the written call option.

Recognizing the Collar

If you are currently long a stock with significant unrealized gains, you should consider implementing a collar. Additionally, if the investor is positive on the company over the long run but uncertain about the firm's short-term prospects, it may be worth considering. They can use the collar option method to safeguard their gains against a stock's downturn. The best-case scenario for an investor is when the underlying stock price at expiry is equal to the strike price of the written call option.

A protected put and a covered call are two tactics used in the protective collar approach. A protected put, also known as a married put, entails owning both the put option and the underlying security. A covered call, also known as a buy/write, involves holding a long position in the underlying securities while selling a call option.

The purchase of an out-of-the-money put option protects the trader from a potentially substantial downward fall in the stock price, whereas the writing (selling) of an out-of-the-money call option earns premiums that should, in theory, equal the premiums paid to buy the put.

The expiry month and number of contracts for the call and put should be the same. The strike price of the bought put should be lower than the stock's current market price. The strike price of the written call should be higher than the stock's current market price. If the investor chooses striking prices that are equidistant from the current price of the owned stock, the transaction should be put up with little or no out-of-pocket expenditure.

This is not a technique for an investor who is exceptionally optimistic on the stock since they are ready to risk surrendering profits on the stock over the covered call's strike price.

Break Even Point (BEP) and Profit Loss (P/L) in Collar

The net of the premiums paid and received for the put and call reduced from or added to the purchase price of the underlying stock, depending on whether there is a credit or debit, is an investor's breakeven point (BEP) on a collar strategy. When the premiums received exceed the premiums paid, the result is a net credit, and when the premiums paid exceed the premiums received, the result is a net negative.

A collar's maximum profit is equal to the call option's strike price less the underlying stock's per-share purchase price. After that, the cost of the alternatives, whether debit or credit, is taken into account. The maximum loss is the amount paid for the item.

The cost of the choice is then taken into account.

(Call option strike price - Net of Put / Call premiums) - Stock purchase price = Maximum Profit

Stock purchase price - (Put option strike price - Net of Put / Call premiums) = Maximum Loss

Example of a Collar

Assume that an investor purchased 1,000 shares of stock ABC at $80 per share, and that the stock is now trading at $87 per share. Due to a rise in general market volatility, the investor wishes to temporarily hedge the position.

The investor buys 10 put options with a strike price of $77 and a premium of $3.00 and writes 10 call options with a strike price of $97 and a premium of $4.50 (one option contract equals 100 shares).

The cost of implementing the collar (buying a $77 strike Put and writing a $97 strike Call) is $1.50 per share.

$80 + $1.50 = $81.50 per share is the breakeven point.

The maximum profit is $15,500, which is calculated by multiplying 10 contracts by 100 shares by (($97 - $1.50) - $80). If the stock price rises to $97 or more, this scenario will unfold.

The maximum loss, on the other hand, is $4,500, or 10 times 100 x ($80 - ($77 - $1.50)). If the stock price falls to $77 or below, this scenario occurs.