Collars
A collar, sometimes referred to as a hedge wrapper, combines two strategies we learned in previous sections: hedging and income strategies. Specifically, it combines a long stock hedge strategy with a covered call.
A collar, in specific terms, is:
- Short call (“out of the money”)
- Long stock
- Long put (“out of the money”)
The most important part of a collar strategy is the long stock. Similar to hedging and income strategies, the stock is the “dominant” part of the investment. The stock’s market price determines the overall return for the investor and whether or not the options will be exercised.
Let’s take a 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 a hedge (protection) for the long stock, even if it’s currently “out of the money.” If the market price falls below $35, the investor can exercise the put and sell the shares at $35. Long puts are not free, and this one costs the investor $300 overall.
The put’s cost is offset by the $300 premium received from the short call, which is why some investors refer to collars as “free (or cheap) insurance.” The $300 received from selling the call has consequences, though. Remember, short calls obligate a sale of stock at the strike price if assigned (exercised).
If the market price rises above $45, the short call goes “in the money” and will be assigned. Regardless of the market price, the investor’s best possible sale price is $45. Essentially, the investor pays for the $300 long put hedge with the $300 short call premium, which places a “ceiling” above their stock (obligation to sell stock @ $45).
This scenario is an example of a “cashless” collar. The cost of the long put is completely offset by the income received from the short call. When an investor can establish a collar (long put and short call) for no net cost, a “cashless” strategy is established.
Let’s take a look at a few examples to understand collars better.
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?
Answer = $500 gain
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Call assigned - sell shares | +$4,500 |
| Total | +$500 |
At $75, the call is “in the money” (“call up”) and the put is “out of the money” (“put down”). The put expires worthless, but the call is assigned (exercised), forcing the ABC shares to be sold at the call’s strike price. Shares were purchased for $40 and sold at $45, creating a $5 gain per share, or $500 overall. The call and put premiums offset each other, leaving the investor with an overall profit of $500.
The investor reaches their maximum gain when the market rises to or above $45. The best possible sale price for the stock is $45 due to the obligation of the short call. Whether the market price goes to $45 or $45,000, the investor locks in a $5 per share gain.
Although the investor made a profit, they’re probably kicking themselves a bit. If they hadn’t bought or sold either option, the shares would’ve gained $35 per share (buy at $40, sell at $75) or $3,500 overall. Another good strategy would’ve been excluding the short call. By doing so, the investor would’ve made $32 per share ($35 gain on the stock minus $3 put premium), or $3,200 overall.
The sale of the call limited the investor’s gains. No matter how high the stock rose, the best possible sale price was $45. This is an example of opportunity cost, which you first learned about in the income strategies section. The short call’s obligation wipes out stock gains above $45 per share.
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?
Answer = $200 gain
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Share value | +$4,200 |
| Total | +$200 |
At $42, the short call and long put are both “out of the money,” resulting in each expiring worthless. Shares were purchased for $40 and are worth $42, creating a $2 gain per share, or $200 overall. The call and put premiums offset each other, leaving the investor with an overall profit of $200.
When the market is between $35 and $45, both options are “out of the money” and will expire worthless. With the two option premiums offsetting each other, the overall gain or loss is all tied to the stock.
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?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Sell value | +$4,000 |
| Total | $0 |
At $40, the short call and long put are both “out of the money,” resulting in each expiring worthless. Shares were purchased for $40 and are worth $40, resulting in no gain or loss. The call and put premiums offset each other, allowing the investor to break even.
Again, both options are “out of the money” and expire worthless when the market is between $35 and $45. With the two option premiums offsetting each other, the overall gain or loss is all tied to the stock.
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?
Answer = $300 loss
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Sell value | +$3,700 |
| Total | -$300 |
At $37, the short call and long put are both “out of the money,” resulting in each expiring worthless. Shares were purchased for $40 and are worth $37, resulting in a $3 per share loss, or $300 overall. The call and put premiums offset each other, leaving the investor with an overall loss of $300.
Once again, we see the stock price between $35 and $45, resulting in two “out of the money” options that expire worthless. With the two option premiums offsetting each other, the overall gain or loss is all tied to the stock.
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?
Answer = $500 loss
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Exercise put - sell shares | +$3,500 |
| Total | -$500 |
At $10, the put is “in the money” (“put down”) and the call is “out of the money” (“call up”). The call expires worthless but the put will be exercised, allowing the ABC shares to be sold at the put’s strike price. Shares were purchased for $40 and sold at $35, creating a $5 loss per share, or $500 overall. The call and put premiums offset each other, leaving the investor with an overall loss of $500.
This example demonstrates how a collar can benefit an investor. The market fell dramatically, but the long put allowed the investor to sell their shares for $35. While a loss still occurs, the investor would’ve lost $30 per share (buy at $40, sell at $10), or $3,000 overall if they only bought shares.
The long put provided a solid hedge (protection) to the investor. Plus, the cost of the put was offset by the sale of the call. This is the best example of how a collar can function as “free insurance.” When the market price falls to or below the put’s strike price, the investor experiences their maximum loss.
For visual learners, options payoff charts can help provide additional context relating to the “big picture” of the option strategy. First, let’s re-establish the example:
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 collar payoff chart shows, there’s a variance of gains and losses between the market prices of $35 and $45, with breakeven occurring at $40. Below $35, the investor has a locked-in loss of $500, no matter how low the market price falls. Above $45, the investor has a locked-in gain of $500, no matter how high the market price rises.
We’ll examine closing the option contracts and selling shares for our last two examples.
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?
Answer = $500 gain
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Close call | -$500 |
| Close put | $0 |
| Sell shares | +$5,000 |
| Total | +$500 |
At $50, the call “is in the money” (has intrinsic value) - “call up.” However, the put is “out of the money” (no intrinsic value) - “put down.” To close the call, the investor must perform a closing purchase of $5 (the call’s intrinsic value), leading to a $2 per share loss on the short call (initially sold at $3, bought to close at $5), or $200 overall. To close the put, the investor must perform a closing sale of $0 (the put has no intrinsic value), resulting in a $3 per share loss (initially bought at $3, sold to close at $0), or $300 overall.
Adding the two losses on the options, the investor has a $500 options loss.
With both options closed, the investor can focus on the stock position. The shares were purchased at $40 and will be sold at $50, netting a $10 per share gain, or $1,000 overall.
To find the final result, combine the losses on the options with the return on the stock. A $500 options loss with a $1,000 stock gain culminates in a final $500 overall profit.
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?
Answer = $400 loss
| Action | Result |
|---|---|
| Buy shares | -$4,000 |
| Sell call | +$300 |
| Buy put | -$300 |
| Close call | $0 |
| Close put | $0 |
| Sell shares | +$3,600 |
| Total | -$400 |
At $36, both options are “out of the money” and have no intrinsic value. To close the call, the investor must perform a closing purchase of $0 (the call has no intrinsic value), leading to a $3 per share gain on the short call (initially sold at $3, bought to close at $0), or $300 overall. To close the put, the investor must perform a closing sale of $0 (the put has no intrinsic value), resulting in a $3 per share loss (initially bought at $3, sold to close at $0), or $300 overall.
Adding the gain on the call and loss on the put, the investor breaks even on the options.
With both options closed, the investor can focus on the stock position. The shares were purchased at $40 and will be sold at $36, netting a $4 per share loss, or $400 overall. With the options breaking even, the final result for the strategy is a $400 loss.
To summarize, collars allow investors to offset the cost of a hedge on their long stock position, preventing significant losses or gains from happening. If the market falls too far, the put is exercised, allowing the investor to sell their shares at a higher price than the market. If the market rises far enough, the call is assigned, forcing the investor to sell their shares at a lower price than the market.
Dog collars may help you remember the specifics of this strategy. Dogs wear collars when they’re taken on walks, which attach to their leash. Due to the collar and leash, the dog can’t move too far away from its owner.
A collar on a stock position is similar. The stock can’t fall too much without the put being exercised, and can’t rise too much without the call being assigned. The stock price the investor will sell their stock at is limited to a small range ($35-$45 in the examples above). Like a dog’s leash and collar, a collar on a stock position won’t let it “move too far.”
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