Collar Trading Strategy: A protective way to manage your risk

What is a Collar Trading Strategy?

A Collar Strategy is like a protective bubble for your stocks. It’s a combination of a covered call and a protective put. Selling the covered call brings in some cash, which you use to buy the protective put. Think of it as making a little side money to buy yourself insurance.

This option strategy involves holding a stock position and simultaneously executing two options trades:

1. Selling a call option on the stock you own.
2. Buying a put option on the same stock.

When to use a Collar Trading Strategy?

Use a collar option strategy when you own stock and want to sleep better at night. The goal is to cover the cost of the protective put with the money from the covered call.

It gives you some downside protection while still letting you make some profit if things go well. Depending on the strike prices, it can cost you nothing, a little, or you might even make some money right away.

Use the collar strategy when you want to:

1. Protect gains in a volatile market by limiting downside risk.
2. Lock in profits if your stock has risen but you expect limited further upside.
3. Hedge a long-term position while reducing the cost of protection through the income from a sold call.
4. Manage risk without selling your stock.

How to set up a Collar Trading Strategy?

1. Own at least 100 shares of stock.
2. Sell a call option above the stock price
3. Buy a put option below the stock price.

This setup limits how much you can make if the stock price rockets, but it also protects you if it tanks. Both the call and put should have the same expiration date and number of contracts.

The further out the expiration, the more you’ll collect from selling the call, but the more you’ll pay for the put. Calls closer to the stock price bring in more money, but puts closer to the stock price cost more. It’s a balancing act to find the sweet spot.

Payoff Diagram of a collar trading strategy

A collar strategy has clear limits on both profit and loss.

1. If the stock goes above the call strike price, you sell the stock at the call price.
2. If it drops below the put strike price, you sell the stock at the put price.
3. If it stays in between, both options expire worthless, and you keep the stock and the premium from the call.

Collar Strategy Example:

• Initial setup: Buy stock at ₹1000, sell a ₹1050 call, and buy a ₹950 put.
• Entry cost: If setting up the collar costs ₹10, the effective cost of the stock becomes ₹1010.

Scenarios:

1. If stock price goes above ₹1050:
   • Profit is capped at the call strike price minus the cost basis.
   • Calculation: (₹1050 – ₹1000) – ₹10 = ₹40 profit per share.
2. If stock price falls below ₹950:
   • Loss is limited to the difference between the stock price and the put strike price.
   • Calculation: (₹1000 – ₹950) + ₹10 = ₹60 loss per share.
3. If stock price stays between ₹950 and ₹1050:
   • Both options expire worthless.
   • The net effect is the initial stock price minus the entry cost.
   • Calculation: Break-even remains at ₹1010.

Entering a collar trading strategy

To start, own at least 100 shares. Sell a call above the stock price and buy a put below it. You can do this even if you already own the stock or you are buying it at the same time. It’s like getting a raincoat and an umbrella when you see dark clouds.

Exiting a collar trading strategy

If at expiration, the stock is:

• Below the put price, sell the stock at the put price.
• Above the call price, sell the stock at the call price.
• Between the two, both options expire worthless, and you keep the premium from the call.

You can also roll the options to extend the trade if you’re not ready to sell the stock

Time Decay impact on a collar trading strategy

Time decay or Theta works differently on the call and put. The call loses value as time goes by, which is good for you. The put loses value too, but it’s your insurance, so ideally, it expires worthless.

Implied Volatility Impact on a collar trading strategy

High implied volatility makes options more expensive. This means you get more money for the call but pay more for the put. The key is to strike a balance that doesn’t cost you too much.

Adjusting a collar trading strategy

A collar strategy can be adjusted if you don’t want to exercise the options at expiration. You can adjust the options up or down or roll them out to a later date.

Example:

• Initial setup: Bought stock at ₹1000, sold a ₹1050 call, and bought a ₹950 put.
• Stock drops: If the stock price drops, you can adjust the call option.
• Adjustment: Buy back the ₹1050 call and sell a new ₹1000 call.

This adjustment brings in more credit, lowering the overall cost of your position.

Rolling a collar trading strategy

Rolling a collar extends the trade. Instead of exercising the options, you can close the current position and open a new one with the same or adjusted strike prices.

Example:

• Initial setup: Bought stock at ₹1000, sold a ₹1050 call, and bought a ₹950 put.
• Adjustment:
  • Close the current position.
  • Open a new position for the next month with the same or new strike prices.

Hedging a collar trading strategy

The collar itself is a hedge. The put protects your stock from dropping too much, so you don’t need another hedge. It’s like having a safety net and a helmet—extra protection for peace of mind.

How Collar Trading Strategy differs from other strategies?

The collar strategy stands out as a balanced approach to protecting gains while limiting downside risk. Here’s how it compares to other common strategies:

1. Protective Put: Unlike a protective put, which only involves buying a put option for downside protection, the collar strategy adds a covered call, which helps offset the put’s cost.
2. Covered Call: While a covered call generates income by selling an option on owned stock, it doesn’t offer downside protection. The collar strategy adds this protection by buying a put option.
3. Bull Call Spread: This bullish strategy involves buying a lower strike call and selling a higher strike call, allowing for gains within a defined range. The collar strategy, however, is less about maximizing upside and more about providing downside protection for stock ownership.

Conclusion

In summary, a collar strategy is your stock’s bodyguard. It limits your upside but shields you from a crash, making it a safe way to manage risk and still make some money.