The collar strategy is a protective options strategy that involves the use of both a long position in a stock and a combination of options positions. Here’s how to use a collar strategy:
- Buy the stock: The first step in implementing a collar strategy is to purchase a stock that you want to protect.
- Buy a protective put: The next step is to buy a put option on the same stock with a strike price that is below the current market price. This put option will provide protection against a decline in the stock’s price.
- Sell a covered call: To offset the cost of the protective put, you can sell a call option on the same stock with a strike price that is above the current market price. This call option generates income, but it also limits the potential profit from owning the stock.
- Adjust the options as needed: If the stock price rises above the strike price of the call option, the call option will be exercised, and you will have to sell the stock at the lower strike price. In this case, you can buy back the call option and sell a new one with a higher strike price to keep the collar in place.
Advantages of the collar strategy
- Downside protection: The protective put provides downside protection, limiting losses in case the stock price drops.
- Income generation: The call option generates income, which can offset the cost of the protective put.
- Limited risk: The maximum loss is limited to the cost of the protective put, minus the income generated from the call option.
- Flexibility: The collar can be adjusted by rolling the options as needed to keep the protection in place.
When to Use the Collar Strategy
The collar strategy can be used in various situations, such as:
- Protection against downside risk: If an investor has a significant amount of stock in a particular company that they do not want to sell, but are worried about downside risk, they can use the collar strategy to protect themselves against a significant loss.
- Hedging a long-term position: If an investor has a long-term position in a stock or other security, they can use the collar strategy to hedge against potential losses while still holding onto the stock for the long-term.
- Generating income: The collar strategy can also be used to generate income by selling call options at a higher strike price than the current market price and using the proceeds to purchase put options at a lower strike price. This strategy limits the potential profit but also provides downside protection.
- Reducing volatility: The collar strategy can help to reduce the volatility of a portfolio by providing downside protection while still allowing for some upside potential. This can be especially useful in uncertain markets or during times of heightened volatility.