The Collar Option: An Explanation

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By Kidgas

Most individuals trading stocks or options have heard of covered calls. Covered calls are often touted as a great way to make income against your stock portfolio. The problem associated with covered calls, however, is that all of your good stocks are called away while the crappy ones are left in your portfolio. A little bit of premium income is little consolation when your stock drops 50% because of a bad earnings report. In other words, your upside is limited while you retain most of the downside risk.

credit: Ad Meskens
credit: Ad Meskens

Protective puts, on the other hand, allow for protection against the downside as well as unlimited upside.  The problem is that these puts cost money.  For a stock moving sideways, puts can be a significant drag on the returns of your portfolio.  There is a way to pay for the cost of the puts by combining protective puts with a covered call.  The result of these combined positions is known as a collar.

A collar consists of a stock position that is protected by puts and against which a covered call has been sold.  The result is that an investor has created boundaries below which the investor cannot lose and above which the investor cannot profit.  The best way to explain is through an example.  Let’s say that you own 1000 shares of AAPL which you purchased in February 2010 at $200 per share.  You are excited about the prospects of the iPad but are concerned that recent market events may take down the entire market especially as we enter the historically weak summer period.  You could protect your profits in AAPL by initiating a collar position that will last through the summer.

To do this, you go into your brokerage account and purchase 10 contracts of the October 230 puts for $14.25 per share.  You would be perfectly happy to sell for $230 per share since you bought at $200, but you don’t want to pay the full cost of the puts.  So, you turn around and sell 10 contracts of the October 270 calls for $13.10 per share.  As a result, you spent $1.15 for protection below $230.  If AAPL is trading at $150, you will still get $230.  If AAPL is trading at $300, you get $270.  Either way you have made a substantial profit and are happy about it.  If AAPL is trading between $230-$270, then you can reassess your interest in the stock in October.

All in all, collars are not a bad deal.  You get protection for little or possibly even no cost to you and a respectable amount of profit potential.  For me and my stock portfolio, collar options offer the best of both worlds.

Comment on Equity Collars

The Rising Glory profile image

The Rising Glory Level 2 Commenter 2 years ago

Explained well. Personally, I don't like Collars...too much profit is eaten up with the put. But a very safe and effective strategy.

Kidgas profile image

Kidgas Hub Author 2 years ago

RG,

Thanks for your comments. I agree that the puts cost money, but I have come to find that protecting capital is worth giving up a little bit of profit. It helps me sleep better but may not be for everyone.

Hello, hello, profile image

Hello, hello, 2 years ago

Your hubs are really eye-openers about so many things which I had no idea. Thank you very much.

Kidgas profile image

Kidgas Hub Author 2 years ago

You are welcome. I enjoy sharing what I know and learning from others.

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