What an incredible bull run the market has been on! Seriously, who would have thought at the beginning of 2020 that we would still be setting all-time highs in February? With many traders and investors thinking that at some point the market is going to move lower (although many have been wrong up until now), it may be time to look at a potential protection strategy using options.

The collar is an often misunderstood but rather simple option strategy that can particularly benefit investors. A collar is having a stock position and buying a put option and selling a call option on the stock. Usually both the call and the put are out of the money (OTM) when establishing this option combination. One collar represents one long put and one short call along with 100 shares of the underlying stock. The main objective of a collar is to protect profits that have accrued from the shares of stock rather than increasing returns.

When to Use 

An investor will usually implement a collar after accruing unrealized profits from shares of stock. Since the market has been on such a highly unusual bullish run, it might be a good time to talk about them. By buying a put, the investor has some protection for the unrealized profits in case the stock declines. The other part of the combination is selling the OTM call. By doing this, the investor is prepared to sell his or her shares of stock if the call is exercised because the stock has moved above the call’s strike price.

The Advantage

The advantage of a collar over just buying a protective put is being able to finance some of or the entire put by selling the call. In essence, an investor buys downside stock protection for free or almost free. Until the investor exercises the put, sells the stock or has the call assigned, he or she will retain the stock.

Volatility and Time Decay

Implied volatility has been really low over the past several months, but volatility and time decay are not usually big issues when it comes to collars. The main reason is that because the investor is long one option and short another, the effects of volatility and time decay will generally offset each other.

Example

An investor bought 100 shares of XYZ at the beginning of the year for $26 a share. Now the stock has climbed to $43 a share and has pulled back with this most recent decline. The investor is worried about the current market conditions and maybe a pending earnings announcement. He or she would like to protect the unrealized gains as year-end approaches. The investor can consider utilizing a collar.
 
The investor can buy a March 40 put for 2.00. If the stock falls, the investor will have the right to sell the shares for $40. At the same time the investor can sell a March 45 call for 2.50. This will make the trade a net credit of 0.50 (2.50 - 2). If the stock continues to rise, it can do so for another $2 until the stock will most likely be called away from him or her.

Three Possible Outcomes

The stock finishes over $45 at March expiration. If this scenario happens, another $2 per share is realized on the stock and $50 on the net credit of the combination is the investors to keep.
 
The stock finishes between $40 and $45 at March expiration. In this case, both options expire worthless. The investor retains the stock and the $50 net credit is his or hers to keep.
 
The stock finishes below $40 at March expiration. The investor can sell the put option if he or she wishes to retain the stock or exercise the right to sell the stock at $40. Either way the $50 net credit is the investor’s to keep.

Conclusion

The nice thing about a collar strategy is that an investor knows the potential losses and gains from the start. There simply is no guessing. If the stock climbs higher, the profits may be suppressed due to the short call. But if the stock takes a dive, the investor has protection due to the long put, and protection might not be such a bad idea if the market corrects itself.

John Kmiecik, Market Taker Mentoring