How the protective collar works

When the market begins to fluctuate wildly, investors usually seek safety, because fluctuations can cause fear among market participants. However, there is no need to panic! A protection collar is an option strategy that provides short-term downside protection, provides a cost-effective way to prevent losses, and allows you to make some money when the market rises. Here, we reviewed the mechanism for initiating this hedging strategy.

Key points

  • Collars are an option strategy used to prevent huge losses but also limit returns.
  • The protective collar strategy involves two strategies, called protective put options and overriding call options.
  • Since you sell one option to fund the purchase of another option, the total cost of implementing this strategy may be very low.

Protection collar strategy

The protective collar includes:

  1. Long positions in underlying securities
  2. Put options purchased to hedge the downside risk of stocks
  3. Call options written on stocks are used to finance a bearish purchase.

The other treats the protection item as a combination of a protective call option and a long put option.

Put options and call options are usually out-of-the-money (OTM) options and must have the same expiration date. The combination of a long put option and a short call option forms the “collar” of the underlying stock, which is defined by the strike price of the put option and the call option. The “protective” aspect of this strategy stems from the fact that put options provide downside protection for stocks until the put options expire.

Protection collar option strategy.
Image courtesy of Julie Bang © investingclue 2019

Since the basic goal of the collar is to hedge downside risks, it is reasonable and reasonable that the strike price of selling call options should be higher than the strike price of buying put options. Therefore, if a stock trades at $50, it may write a call option at a strike price of $52.50 and buy a put option at a strike price of $47.50. The $52.50 call option strike price provides an upper limit on the stock’s return because it can be cancelled when its trading price is higher than the strike price. Similarly, the put option strike price of $47.50 provides a lower limit for the stock because it provides downside protection below that level.

When to use a protective collar

When investors need short- and medium-term downside protection, they usually implement a protection collar, but the cost is lower. Since purchasing protective put options can be an expensive proposition, writing OTM call options can pay a considerable amount for the cost of put options. In fact, it is possible to construct protective collars for most “no-cost” (also known as “zero-cost collars”) or for stocks that actually generate net credit for investors.

The main disadvantage of this strategy is that investors abandon the rise of stocks in exchange for downside protection. If the stock falls, the protective collar works like a charm, but if the stock rises and is “recovered”, it will not work well, because any additional gains above the bullish strike price will be lost.

Therefore, in the previous example, on a stock trading at $50, write a guaranteed call option at a price of $52.50. If the stock subsequently rises to $55, then the investor who writes the call option will have to Give up the stock at a price of $52.50 and give up an additional $2.50 profit. If the stock rises to $65 before the call option expires, the author of the call option will give up the extra $12.50 (that is, $65 minus $52.50) in profit, and so on.

The protective collar is particularly useful when the market or specific stocks show signs of falling after a sharp rise. They should be used with caution in a strong bull market, because the possibility of stocks being eliminated (thus limiting the upside of a particular stock or portfolio) can be quite high.

Make a protective collar

Let us understand how to build a protective collar using a historical example of Apple, Inc. (AAPL) options whose stock closed at $177.09 on January 12, 2018.Suppose you hold 100 shares of Apple stock that you bought for $90, and the stock is 97% higher than your purchase price, and you want to implement a collar to protect your income without actually directly selling your stock.

You start by writing a guaranteed phone call about your Apple position. For example, suppose that the trading price of a call option of $185 in March 2018 was $3.65/$3.75, so you write a contract (with 100 AAPL shares as the underlying asset) to generate a premium income of $365 (minus commissions) . You also bought a contract for a $170 put option in March 2018 at a transaction price of $4.35/4.50 and a cost of $450 (plus commission). Therefore, the net cost of the collar (excluding commissions) is $85.

Scenario analysis

Here is how the strategy works in each of the following three situations:

Scenario 1-Just before the expiration date of the rights on March 20, Apple’s transaction price is higher than $185 (for example, $187).

In this case, the trade price of the $185 call option is at least $2, and the trade price of the $170 put option is close to zero. Although you can easily close a short call position (recall that you earned a premium of $3.65 for this), let us assume that you did not and are satisfied that your Apple stock was redeemed at a price of $185.

Your overall profit will be:

[($185 – $90) – $0.85 net cost of the collar] x 100 = 9,415 USD

Recall the collar we mentioned earlier about rising stocks. If you did not implement the collar, your earnings on Apple’s position would be:

($187-$90) x 100 = $9,700

By implementing the collar, you must give up the additional earnings of $285 or $2.85 per share (that is, the difference of $2 between $187 and $185, and the cost of the collar of $0.85).

Scenario 2-Shortly before the expiration date of March 20, Apple’s transaction price is less than $170 (for example, $165).

In this case, the trade price of the $185 call option is close to zero, and the $170 put option is worth at least $5. Then, you exercise your right to sell your Apple stock for $165. In this case, your total income will be:

[($170 – $90) – $0.85 net cost of the collar] x 100 = 7,915 USD

If you don’t set up a collar, your Apple stock return will only be $7,500 (the difference between the current price of $165 and the initial cost of $90 x 100 shares). Therefore, the circle helped you realize an additional $415 by providing downside protection for your AAPL.

Scenario 3-Shortly before the expiration of the rights on March 20, Apple’s transaction price is between $170 and $185 (for example, $177).

In this case, the trading price of the $185 call option and the $170 put option are both close to zero, and your only cost is the $85 incurred by the implementation of the collar.

The nominal (unrealized) income of your Apple shares will be

US$8,700 (US$177-US$90) minus the cost of the collar of US$85, or US$8,615

Tax advantage

A collar may be an effective way to protect the value of your investment, and your net cost may be zero. However, it has some other points that can save you (or your heirs) taxes.

For example, what if you own a stock that has risen sharply since you bought it? Maybe you think it has more upside potential, but you worry that other parts of the market will pull it down.

One option is to sell the stock and buy it back when the market is stable. You can even get it at a price lower than the current market value and earn a few dollars more. The problem is that if you sell, you will have to pay capital gains tax on your profits.

By using the collar strategy, you will be able to hedge the market downturn without triggering a taxable event. Of course, if you are forced to sell the stock to holders of call options or decide to sell to holders of put options, you will have to pay taxes on your profits.

You can also help your beneficiaries. As long as you do not sell your shares, they can take advantage of the rising basis when they inherit shares from you.

Bottom line

Compared to just buying protective put options, a protective collar is a good strategy to obtain downside protection in a more cost-effective manner. This is achieved by making OTM call options on the stocks held and using the premium received to purchase OTM put options. The trade-off is that the overall cost of hedging downside risks is lower, but the upside potential is limited.


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