You have options to help protect yourself in the event of a potential stock market decline. If you're looking to protect gains on existing stock positions, or you are moderately bullish on a particular stock but could be concerned about a short-term downturn, you could consider the collar options strategy.
Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses. There are 3 components to constructing a collar:
This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.
The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), which obligates the seller to sell the underlying stock if it rises above your call strike price at expiration or is assigned. Note that you are paying commissions for both sides of the trade.
You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you are no longer bullish on the stock.
A closer look at collars
Now that you have a basic idea of how this strategy works, analyzing a specific example can help illuminate some of the intricacies involved in the collar. (Note that before placing a collar trade with Fidelity, you must fill out an options agreement and be approved for the appropriate options trading level).
In our example, we will look at a hypothetical scenario for XYZ stock.
You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).
The breakeven price, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).
Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit (i.e., money you paid out) of $15 to construct the collar, you made a 2-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.
Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received. This offsets some of the loss you have experienced on the stock.
Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.
In sum, you still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock), but it's less than the $400 that you would have incurred without the collar. This highlights how the collar provides protection in a down market.
Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.
Collar the market
If you expect a stock to be bearish over the short-term, the collar options strategy may be worth considering. With experience, you can learn how to adjust the expiration date and strike price on each side of the collar to maximize your risk and return objectives.
Next steps to consider
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