An equity collar is generated by selling an equal number of call options and buying the same amount of put options on a long stock position. It protects the downside risk of a stock position while limiting the upside potential.
Holding shares of the underlying stock while simultaneously buying protective puts and selling call options against the holding one creates a collar. The puts and calls are both out-of-the-money options having the same expiration.
This hedge requires a combination of option calls and puts and therefore is only suitable for savvy investors.
Protection is robust at the expense of profit potential.
Zero to Low
Many times, there is no cost in generating collars due to premiums offsetting expenses.
An investor owns 100 shares of XYZ stock that is trading for $48 in June. They create a collar by writing (selling) a JUL 50 covered call for $2 while simultaneously purchasing a JUL 45 put for $1.
The total investment is $4700 based on the following:
On the expiration date, the stock loses 5 points, settling at $43. Now the strike price of $50 for the call option is higher than the trading price of the stock. Thanks to the JUL 45 protective put, they sell for $4500 instead of $4300, limiting the loss to just $200.
If the stock gained 5 points on the expiration date, reaching $53, we then have a different scenario. Now the strike price of $50 for the call option is lower than the trading price of the stock. The investor sells his shares for $5000, resulting in a profit of $300 ($5000 minus $4700 original investment).
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.