Collar (finance)

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A collar is an investment strategy that uses options to limit the possible range of positive or negative returns on an investment in an underlying asset to a specific range. To do this, an investor simultaneously buys a put option and sells (writes) a call option on that asset. The strike price on the call needs to be above the strike price for the put, and the expiration dates should be the same.

After establishing the portfolio in this manner, the return on the portfolio will between the strike price on the call (potential profit), and the strike price on the put (potential loss), meaning your possible gains and losses will always be within a preset limit.

1 Example
2 Why do this?
3 References
4 See also

[edit] Example

Say you own 100 shares of a stock with a current price of $5. Calls on the stock are traded with a strike price of $7 and puts are traded with a strike price of $3. You could construct a collar where you know that your gain on the stock will be no higher than $2 and your loss will be no worse than $2, by buying 1 put and selling 1 call.

There are three possible scenarios when the options expire:

If the stock price is above the $7 strike price on the call you sold, the guy who bought the call from you will exercise his call, and you will have to sell him your shares at $7. This would lock in a $2 profit for you. You only make a $2 profit, no matter how high the share price goes.

If the stock price has dropped below the $3 strike price on the put you bought, you will exercise your put and the guy who sold it to you is forced to buy your shares at $3. You lose $2 on your stock, but you can only lose $2, no matter how low the price of the stock goes.

If the stock price is between the two strike prices at the expiration date, both options expire unexercised, and you are left with your shares of the stock.

[edit] Why do this?

In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if you just sold the stock, you would get $5. This is fine, but it poses additional questions. Do you have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating your portfolio? Would you really rather just hold onto the stock? What are the tax consequences?

If it makes more sense to hold on to the stock (or other underlying asset), you can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another nice thing is that the cost of setting up a collar is (usually) free or nearly free. You use the price you receive for selling the call to buy the put - one pays for the other.

Finally, using a collar strategy takes your return from the probable to the definite. That is, when you own a stock (or another underlying asset) and have an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their likelihood. You may get a higher or lower return. When you own a stock (or other underlying asset) and you use a collar strategy, you know for sure that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.