What is a Collar Option Strategy?
A collar option strategy also referred to as a hedge wrapper or simply collar, is an option strategy employed to reduce both positive and negative returns of an underlying asset. This limits the return of the portfolio to a specified range and can hedge a position against potential volatility of the underlying asset. A collar position is created through the usage of a protective put and covered call option. More specifically, it is created by holding an underlying stock, buying an out of the money put option, and selling an out of the money call option.
Quick Summary of Points
- A collar option strategy is an option strategy that limits both gains and losses
- A collar position is created by holding an underlying stock, buying an out of the money put option, and selling an out of the money call option
- Collars may be used when investors want to hedge a long position in the underlying asset, from short-term downside risk
Interpreting the Collar Option Strategy
The collar option strategy will limit both upside and downside. The collar position involves a long position on an underlying stock, a long position on the out of the money put option, and a short position on the out of the money call option.
By taking a long position in the underlying stock, as the price increases, the investor will profit. As the price decreases, the investor will experience a loss. Holding a long position on an out of the money put option, as the price of the underlying stock decreases, the put option value increases. We see here that the downside of a falling stock price is neutralized by the put option. The investor will also take a short position on an out of the money call option. If the price of the underlying stock increases, the call option will be exercised by the buyer. Therefore, as the seller, you will experience a loss as the underlying asset increases in price. This potential loss neutralizes the upside of holding the stock.
The value of the underlying asset between the strike price of the put option and call option is the value of the portfolio that moves. The loss experienced by the call option above the call strike price will cancel with gains from the stock appreciating, therefore the payoff will be flat here. The gains experienced by the put option below the strike price will cancel with the loss from the depreciating stock price. The payoff will also be flat here. Below we can see what the payoff diagram of a collar would look like.
Collar Option Payoff Diagram
The payoff of a collar can be understood through the use of a payoff diagram. By plotting the payoff for the underlying asset, long put option, and short call option we can see what the collar position payoff would be:
Here we see that below the put strike price (Kp) and above the call strike price (Kc), the payoff is flat. The potential upside and downside of this portfolio is limited. It is only between the strike prices that we see the payoff movement of a collar position.
Uses of a Collar Option Strategy
A collar option strategy is most often used as a flexible hedging option. If an investor has a long position on a stock, they can construct a collar position to protect against large losses. This is through the usage of the protective put option that will gain when the underlying asset falls in price. The covered call option is sold which can be used to pay for the put option and it will still allow potential upside from an appreciation in the underlying asset, up to the call’s strike price. When the entire cost of the put option is covered by selling the call option, this is referred to as the zero-cost collar.
If a stock has strong long-term potential, but in the short-term has high down-side risk then a collar can be considered. Investors will also consider a collar strategy if a stock they are long in has recently appreciated significantly. To protect these unrealized gains a collar may be used. The use of a collar strategy is also used in mergers and acquisitions. In a stock deal, a collar can be used to ensure that a potential depreciation of the acquirers stock does not lead to a situation where they must pay much more in diluted shares.
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