Generally, collars are used by investors when they want to protect a profitable equity position by setting an exit point. But many investors fail to realize what collars can do to protect your equity position, particularly for a volatile stock. We are smack dab in the middle of quarterly earnings, and now might be as good a time as any to discuss this somewhat simple, but effective, option strategy.

A collar is holding shares of stock and buying a put and selling a call on the position. Usually both the call and the put are out-of-the money when establishing this option combination. One collar represents one long put and one short call along with 100 shares of the underlying stock. One of the main objectives of a collar is to protect the shares of stock from decreasing in value rather than increasing returns.

At the time of this writing, Tesla Inc. (TSLA) is expected to announce earnings next week. If an investor is trying to protect his or her stock position from a gap lower after the announcement, he or she can consider a collar. Selling a call option limits the gains if the stock gaps higher rather than lower, similar to how a covered call would limit gains on a stock position. But a collar is done to pay for some if not all of the long put’s premium. As I like to say, there are always tradeoffs with options trading.

At this time, TSLA is trading at around $285. A May-04 300 call can be sold for around 6.00, which can be used to purchase a May-04 270 put for around 6.00. The sold call pays for the long put, and the position protects the stock from further losses below the $270 level without any additional cost minus commissions. The 270 long put gives the owner the right to sell the stock at $270 up till expiration. The tradeoff is if the stock gaps above $300, the 100 shares will be called away at $300 because they will expire in-the-money (ITM) and be automatically assigned. This means your long 100 shares will be sold at $300 regardless of how high they are trading at expiration.

Collars don’t always make sense. But when a potential earnings report could lead to a sizable gap, an investor should consider the alternatives, which might be a lot worse.

John Kmiecik, Market Taker Mentoring