What is Collar Option strategy
As a rookie investor, you’re in good standing to try out Collar Option strategy. Let’s rewind for a second and explore this fascinating trading strategy and how it can benefit you in your financial portfolio. Assuming that you want to invest in share ABC on the ASX at your favourite online FX trading platform, you may be tempted to run a collar if ABC has enjoyed a bull run on the market.
Why? Because you want to protect your unrealised gains before the market turns against you.
Sometimes, investors will attempt to sell the call with plenty of juice (premium) to completely pay for the product. If there is a net-zero cost to this collar option, it’s known as a zero-cost collar. Savvy? It’s a little complicated mate, so let’s get right to the meat of the matter with an example:
- You Own or Buy 100 shares of ABC at AU$100
- Sell 1 option of ABC 105 call at AU$1.80
- Buy 1 option of ABC 95 put at AU$1.60
What you are doing here is buying ABC shares while simultaneously buying protective puts on ABC shares and selling covered calls on ABC shares on a share-by-share basis. In our example, you can see that 100 shares of ABC are bought. 1 share of ABC (out-of-the-money) call is sold, and 1 share of ABC (out-of-the-money) put is bought.
What does this all mean?
The share price of ABC may fall. If this happens, the put option that was purchased (1 share of ABC 95 at 1.60) offers a degree of protection below the strike price until the expiration date is reached. Now, it may well happen that the share price increases. In that case, your profit will be limited to the strike price of the covered call option (less fees, commissions, transaction charges, margins, and taxes).
*Options are typically 100 shares
Equity Collars in Action
Most investors with large holdings in shares tend to use equity collars, especially when they are worried about a potential downside to their shareholdings. Selling shares is often not an option for several reasons. You may not want to sell your shares because it would send the wrong message to the company board (if you have a large shareholding in the company), or simply because the capital gains taxes on the realised gains would be too great. For these investors, equity collars are the ideal solution. By relinquishing some of the shares’ upside potential, it is possible to derive downside protection at minimal cost.
When using equity collars, your objective is to get the lowest possible cost of protection that is available by buying puts and selling calls such that the cost of the puts is largely offset by the premiums that are derived from writing the call options.
If no net premium (no additional charge) is due, the investor scores a big win with what is known as a zero-cost collar. Using our example from above, if an investor owns 100 shares of ABC which are currently trading at AU$44.75, the investor could buy 1 x 10-month ABC 40 put at AU$4.75 and sell 1 x 10-month ABC 55 call at AU$4.50. Then a premium for this collar is just AU$0.25 (AU$4.75 – AU$4.50).
Making Sense of the Collar Option strategy for Share Holdings
If you have invested in ETFs and shares, your rationale is that you expect these financial instruments to increase in value. Even with minimal experience in the financial markets, you are aware that prices can appreciate or depreciate at will. If you suspect that the price of your asset holdings will fall, you have several available options. You can wrap your investments with a collar, to protect them from the downside risk. You can do this if you’re prepared to relinquish the upside potential of the asset.
There Are 3 Parts to a Collar:
- You own shares
- You buy a Put Option
- You sell a Call Option
The asset that you already own is either an ETF or shares. Remember that options require ownership of at least 100 shares; so, that is the minimum benchmark for Collar Option strategy. Now, you must purchase a put option below the strike price of the shares you already own. For example, if you bought your shares for a strike price of AU$100, the strike price of the put option must be less than that amount. The price level is known as the floor of your put option and it gives you the right to sell your shares at that price level.
Put options increase in value as the price of the underlying asset decreases. Profits generated from the puts can function as the perfect hedge against falling prices in your asset holdings. When you finance your put purchase with the sale of a call option (at a chosen strike price) above the underlying price – known as the price ceiling – the premium that you receive from the option can offset most of your expenses.
Buying Put and Selling Call Options to Shore Up Your Investments
Options are offered on a per share basis and they are priced accordingly. To offset the cost of the put, you can sell your call option at a higher price than the strike price. You can calculate your overall cost of the collar as the difference between the put and the call options. You can think of a share being collared when it has an upper price known as a ceiling and a lower price known as a floor. Your share fits snugly between the call and the put options.
FUN FACT: If you use your own money to fund equity collars, that is different than using other peoples’ money (such as the bank’s money). This is known as a ‘Funded Equity Collar’. The lender in this case uses the borrower’s stake in the company as a collateral for the loan. The volatility of the shares in question determines the risk that the lender undertakes.
If the share price plummets, the put option serves as security to you since it limits your downside exposure to risk. In this case, the call option can expire, and it has no bearing on your asset holding. With collar options, the maximum loss that you can be subjected to is the difference between the share price (purchase price) and the put strike price, minus any credit received, and any debits paid.
So, if the put option is AU$10, less than the strike price, and the collar is AU$0.20, your maximum loss is limited to AU$10.20. If your share appreciates in value (which can easily happen too), then the put option expires and is worthless to you. But the cost of the collar in this case (AU$0.20) must be subtracted from the profit of $10 for a total profit of AU$9.80.
It is a little complicated, but if you pay attention to the details, it is easy to understand. You’re basically buying a price ceiling for X amount of AUD and buying a price floor for X amount of AUD. If the price of your shares or ETF rises above or falls below those levels, you can exercise your right to sell and mitigate your losses to the downside.
Collar option main FAQs
- What is a protective collar strategy?
A protective collar combines ownership of the actual stock with options in order to limit both the upside and downside of the stock position. In addition to owning the stock in a protective collar the trader will simultaneously sell a covered call and buy a protective put. One of the great benefits of this strategy is that it can be implemented at almost no cost since the premium received from the covered call offsets the cost of the protective put. The collar ensures that the most that can be lost is the difference between the current price of the stock and the strike price of the protective put.
- What is a reverse collar?
The reverse collar is a hedging strategy that is used to protect a position from declining prices. Like most collars it involves buying both calls and puts simultaneously. In the case of the reverse collar these have the same expiration date, but different strike prices. The reverse collar is implemented by a trader buying calls and selling puts. In many cases there is very little cost to implementing this type of collar. It basically serves as protection against a sudden move lower in the price of the asset, and can be used successfully to protect an open position around earnings releases, or other significant news events that are likely to cause price volatility.
- What is a three-way collar?
A three way collar begins in the same way as a traditional collar, with the trader selling a call option and buying a put option simultaneously. At this point the collar is usually costless or nearly so and provides downside protection for the trader. It becomes a three-way collar by the addition of the trader selling another put option that is further out of the money. The trader pockets the premium from the sale of this put as profit. However, there is a risk that the price could drop sharply and the lower cost put will expire in the money.