Collars

A collar (sometimes called a hedge wrapper) combines two strategies you’ve already seen: hedging and income strategies. In practice, it’s a long stock position protected by a long put, with the put’s cost often offset by selling a covered call.

A collar, in specific terms, is:

• Short call (“out of the money”)
• Long stock
• Long put (“out of the money”)

The key position in a collar is the long stock. The stock is the “dominant” part of the strategy: the stock’s market price drives the overall result and determines whether either option will be exercised.

Let’s look at an example:

Short 1 ABC Jan 45 call @ $3

Long 100 shares of ABC stock @ $40

Long 1 ABC Jan 35 put @ $3

The long put is the hedge (protection) for the long stock, even though it starts “out of the money.” If the market price falls below $35, the investor can exercise the put and sell the shares at $35. That protection isn’t free: the put costs $3 per share, or $300 total.

In this example, the put’s $300 cost is offset by the $300 premium received from selling the call. That’s why collars are sometimes described as “free” (or cheap) insurance.

The call premium comes with a trade-off. A short call creates an obligation: if assigned, the investor must sell the stock at the call’s strike price.

• If the market price rises above $45, the short call becomes “in the money” and will be assigned.
• No matter how high the stock goes, the investor’s best possible sale price is $45.

So, the investor is effectively using the $300 call premium to pay for the $300 put hedge, but that also places a ceiling on the stock’s upside (an obligation to sell at $45).

This is an example of a “cashless” collar: the cost of the long put is completely offset by the premium received from the short call. When the collar (long put + short call) is established for no net cost, it’s considered “cashless.”

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Let’s work through a few examples to see how collars behave at different stock prices.

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. What is the gain or loss if the market rises to $75?

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What if the market rises by a small amount?

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. What is the gain or loss if the market rises to $42?

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What happens if the market is flat?

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. What is the gain or loss if the market stays at $40?

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What happens if the market falls by a small amount?

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. What is the gain or loss if the market falls to $37?

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What happens if the market falls significantly?

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. What is the gain or loss if the market falls to $10?

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For visual learners, an options payoff chart can help you see the strategy’s “big picture.” Here’s the same position again:

Long 100 shares of ABC stock @ $40

Short 1 ABC Jan 45 call @ $3

Long 1 ABC Jan 35 put @ $3

Here’s the payoff chart:

The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.

As the payoff chart shows:

• Between $35 and $45, gains and losses vary with the stock price, with breakeven at $40.
• Below $35, the loss is locked at $500, no matter how low the stock falls.
• Above $45, the gain is locked at $500, no matter how high the stock rises.

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The last two examples show what happens when the investor closes the option contracts and sells the shares at the market price.

An investor buys 100 shares of ABC stock at $40, goes short 1 ABC Jan 45 call at $3, and long 1 ABC Jan 35 put at $3 when the market price is $40. The market price rises to $50, the contracts are closed at intrinsic value, and the shares are sold at the market price. What is the gain or loss?

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Let’s try one last example involving closing the option contracts and selling the shares:

An investor buys 100 shares of ABC stock at $40, writes 1 ABC Jan 45 call at $3, and holds 1 ABC Jan 35 put at $3 when the market price is $40. The market price falls to $36, the contracts are closed at intrinsic value, and the shares are sold at the market price. What is the gain or loss?

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To summarize, collars let investors reduce the cost of hedging a long stock position by using call premium to help pay for a protective put.

• If the market falls far enough, the put can be exercised, allowing the investor to sell shares at the put’s strike price (higher than the market).
• If the market rises far enough, the call can be assigned, forcing the investor to sell shares at the call’s strike price (lower than the market).

A simple way to remember the idea is the “dog collar” analogy. A dog on a collar and leash can’t move too far away. Similarly, a collar on a stock position keeps the outcome within a range: the stock can’t fall too far without the put protection kicking in, and it can’t rise too far without the call obligation limiting gains. In the examples above, the effective sale range is limited to $35-$45.

Key points

Collars

• Components:
  • Short call (“out of the money”)
  • Long stock
  • Long put (“out of the money”)
• Provide a cheap or free hedge on stock
  • Call premium offsets the put premium
• May be referred to as a hedge wrapper