A Collar option strategy is a multi-legged strategy created by combining a long stock
position, out-of-the-money covered call options, and out-of-the-money protective put option contracts. When the trader combines all these options contracts, their risk factor gets defined, and the profit potential on the position is limited.
We saw that the collar strategy is formed by combining the covered call and protective
put options. By selling the covered calls, traders will receive the credit, which will help offset the buying cost of the protective put.
Collar option strategy from the market's perspective:
Traders use this strategy when holding long stock and wish the risk should be defined on their position. The main objective of entering into this strategy is to compensate the cost incurred in the long put with the credit received from the short call. In this collar strategy, the protective put options provided protection against any downside risk via earnings received from the covered call. Traders may enter this strategy for debit, credit, or cost-free positions based on the width spread of the collar's strike prices.
How can I set up a collar strategy?
The compromised upside risk potential can be offset by protecting the downside risk. To set up a collar strategy, a trader must have or buy at least 100 shares of the stock, combine them with the covered call option above the stock price, and with a protective put below the stock price. Here, traders must ensure that the call and put side of the collar has the same expiration date and an equal number of contracts. Traders can choose any strike price they want for the call and put options along with the expiry date.
When entering the position, short call options will receive more money if the strike price is further from the expiry; on the other hand, the long-put options will be expensive. Again, if the option is close to the stock to the stock price, traders collect more on the call options and have to pay more for the put options.
Some collars may not have any cost to enter, while some enter for debit or credit based on the strike price of the short-call options and long puts. Traders preferred to enter the collar strategy at no cost or for credit, but sometimes they might have to pay a small debit. This debit patent arises because of the put-call parity in the pricing. A Put option that is at an equal distance from the stock as from the call option will generally be costly. So, if the traders wished to enter the strategy without incurring any cost, they needed to have a slight skew in both strike prices. Here the strike price of the call option will be closer to the stock price as compared to the put option of the underlying stock.
For example: a collar strategy is currently being traded at Rs.100, a trader can enter a call option for debit by paying Rs.105, and a put option for credit by paying Rs. 95, Or credit with Rs. 104 for call options and Rs. 95 for put options, or to enter without any cost, traders have to pay Rs. 105 for the call option and Rs. 94 for the put option.
Understanding the diagram of the collar strategy:
The diagram of the collar strategy represents the highest profit and loss. Suppose the stock closes in-the-money at the time of expiry; traders may sell the shares at the short call strike price or long put strike price. If the stock closes between the two levels at expiry time, both call and put options will expire worthlessly. Traders may have te credit received by selling the call option, which will be used to offset the cost paid for buying the put option.
Traders may enter the collar strategy by paying nothing, credit or debit, based on the
strike prices of the call and put options contract. When traders sell the call options at a price closer to the stock price, they receive more credit, and when they buy put options contracts at a price closer to the stock price, they have to pay high. Generally, every trader wishes to enter the collar strategy at no cost or for credit.
For example: suppose a stock is currently traded at Rs. 100 in the market, and the trader wants to enter the collar strategy on this stock. One scenario is a trader can sell the call option at Rs.105 and buys the put options at Rs. 95. If while entering the position, the trader incurred the cost of Rs. 1. The cost basis of the long position will Rs.101 from Rs.100. The collar strategy will help limit the profit potential above Rs. 105. Still, the long stock will get protection from any downward price fluctuation from Rs. 95. If the stock closes below Rs. 95. Traders may have the maximum loss of Rs. -600, and the highest profit will be Rs. 400 in case the stock closes above Rs. 105 at the time of expiry. (Rs.100 + Rs. 5 -Rs. 1 premium).
How can I enter the collar strategy?
A collar strategy is created with the stock ownership of the trader. Traders may pre owned the stock or buy simultaneously with short call and long put. The collar strategy is made up of the covered call options and protective puts. To enter the collar strategy, the trader sells the call options above the stock price, and a protective put is bought below the stock price. Both will have the same contracts and the same expiry dates. Collars are entered without any cost or for debit or credit based on the strike price of the call and put options. When sold near the stock price, the call options receive high credit, and the put options bought near the stock price will be equally costly. The investors' or trade's preference is always to enter at no cost or for credit, but sometimes traders might have to pay a small debit to make the collar strategy effective.
For example: suppose a trader had bought the stock at Rs. 100. He can sell the call
option at Rs. 105 and buy a put option at Rs. 95. Due to the parity in the call and put
option pricing, the put options strike price from the stock will be more costly than the
call option's strikes from the stock price. So, if the trader wants to enter at no cost,
then he must allow some skew in the prices of the option contract in relation to the
stock price.
How can I exit from the collar strategy?
Traders can exit the strategy if the short call or long put options are in-the-money at
the expiry time. In the above case, the traders exercise the options contracts by selling
the stock at their corresponding prices. If none of the options is in-the-money at the
time of expiry, then both contracts will expire worthlessly. Traders may enter an entirely
new position expiring on some future date.
Impact of time decay factor on the collar options strategy?
The impact of the time decay in collar strategy will be different for call options and put options. The time decay or theta affects the short options positively and the long options negatively. In this strategy, the protective puts are supposed to control the downside risk, not to make money. Protective puts expire worthlessly, and the value of the short call options will decrease as time passes.
Impact of the implied volatility on the collar strategy?
The price of the premium will be affected by the implied volatility in the underlying stock. The higher the rate of volatility, the more costly the stock. The rate of implied volatility may positively affect the call option contract and negatively to the put option contracts. Traders execute the collar strategy only if they expire in-the-money. Any change in the volatility does not affect the position while still in the trade.
How can I adjust the collar strategy?
If traders do not want to execute the collar strategy at the time of expiry, they can adjust it. Adjustment is made if traders are willing to keep the long stock position. The challenged stock can be adjusted up or down or rolled to some future expiry date. Suppose the long-put option contract is being challenged; the trader can adjust the short call by buying the original call and selling a new contract at the closer stock price.
For example: if a trader has entered a collar strategy with a call option at Rs.105 and a put option at Rs. 95, the stock has declined. Here, traders can buy the call option at Rs.105 and sell the original call option of Rs. 100. by doing so, additional credit will be received, and the overall cost of the position will be reduced. In case the stock has declined, and there is a belief that it will rise in the future, or if the stock has rallied and there is a belief that it will climb more, in both the above scenarios, the collar strategy can be rolled to some future date.
How can I roll the collar strategy?
Traders can roll the collars like any other strategy to extend the trade duration. Rolling
is made if the traders do not wish to execute their rights and want to stay in the position.
To roll the collar strategy, traders need to exit from the existing position and enter the
new one. To exit from the strategy, they need to order buy-to-close (BTC) covered call
options and sell-to-close (STC) protective put option contacts at later expiry dates. Traders may choose to keep the same strike price of the new position or may choose
a different strike price, either upwards or downwards, based on the current stock price.
How to hedge the collar strategy?
Generally, the collars are not supposed to hedge as the strategy is used to protect the
position against any potential downside risk in the long stock position. The protective
put option contract will be used as the security in case the price of the stock declines.
Hence it creates a bullish bias and hedges the investment which a trader has owned
for a long time.
So, it was all you need to know about the collar strategy. The above was the theory part
and can get more complex when applied practically, so if you are interested, contact
us and know how to use the collar strategy to limit the risk from both directions.