DESCRIPTION: A collar is an adjunct to an existing a long position, and is used to limit potential losses. To protect that long position, one buys a put and pays for it by selling a call. The strategy takes the benefits of two hedging strategies, (1) selling a call for protection against a small loss and (2) buying a put for protection against a large loss.
MOTIVATION: The investor who buys a collar is concerned about a correction in the price of an asset they own or plan to buy. Properly designed, a collar will protect against a large loss while providing some room to capture some capital gains should the asset price rise.
OUTLOOK: The investor who straddles a stock is looking for a modest rise in the price of an asset but is concerned about a sharp decline. The An example would be an institutional investor who has a large position in a stock were its near term promise is cloudy due to industry issues or potential changes in regulation, that could adversely impact the company. The investor wants protection against a temporary hit to the value of their holdings.
MAXIMUM GAIN: Call Strike – Stock Price – Premium Paid + Dividends
The price appreciation is capped at the price of the call option sold. Since the investors holds the stock, they are entitled to the dividend paid on that stock, if any.
MAXIMUM LOSS: (Put Price – Stock Price) – Premium Paid + Dividend
The most one can lose is the difference between the price of the stock and the strike price of the put plus the premium paid, less the dividend collected, if any.
BREAKEVEN: Stock Price – Premium + Dividend
The breakeven level is equal to the stock price less the premium paid to buy the collar plus the dividend collected if any.
VOLATILITY: Nominal. A change in implied volatility has little if any effect on the value of a collared stock. The gains made on the long put, are offset by a loss on the call sold.
TIME DECAY: Nominal. Time decay has little effect on the performance of the collared stock. The premium paid to put the put is offset by the premium collected on the call sold. By adjusting the strikes, one can manage the premium paid or collected, which drives the time decay characteristics.
ASSIGNMENT RISK: Nominal. The owner of a collared stock can have the stock taken away if the price of the stock rises above the strike price of the call. If that occurs, the investor will hold cash and a put option, which will have to be sold.
EXPIRATION RISK: Nominal. If the share price falls below the strike price of the put, the investor can exercise the put and sell the stock or sell the put. In this case, the investor is in control. If the share price rises above the strike price of the call, their stock will be called away, and the investor will then hold cash.