Options 101: The Collar Strategy

Another protective strategy that allows for some upside capital gain while providing maximum down side protection is the collar.

Thecollar is a combination of the covered call and protective put strategies. The collar uses a long put position in coordination with a short call position along with a long stock position. In other words, it is a protective put added to a covered call.

The ratio is one short call, one long put (not of the same strike) and 100 shares of stock.

As you remember, one contract is equal to 100 shares. The options that we will use to construct this strategy will be out-of-the-money puts and calls.

The object here is to construct a protective put strategy without having to pay for the purchase of the put. We talked about premium in the covered call strategy and how we are better off collecting premiums over a period of time -- not paying them. By selling the call, we collect premium which can be used to offset the capital outlay we incurred for the put purchase.

We said that two of three scenarios in the covered call strategy were positive while the protective put scenario had only one scenario that produced a positive outcome.

However, the protective put was the strategy that provided the most downside protection. The challenge was to construct a protective put strategy without paying out money. The solution is the collar strategy.

The collar takes on the characteristics of both the protective put and covered call strategies. Like the covered call, there is an upside cap on profits and like the protective put there is unlimited downside protection.

Ideally, the collar is set up to be an "even" trade meaning you neither receive nor pay out any money. Realistically, depending on the options used, you may have to pay out a small premium or even receive a small premium but the goal of the collar in terms of premium is to be neutral.

As mentioned previously, to construct a collar, just buy one out-of-the-money put and sell one out-of-the-money call per every 100 shares of stock owned. Obviously, the put and the call must be of differing strikes (it is impossible for a put and a call of identical strike price to both to be out-of-the-money or both to be in-the-money).

For example, with a stock priced at $28.50 a collar may be constructed by the purchase of the December $27.5 puts and the sale of the December $30 calls. Hopefully, the price of the call and put are close enough so that the funds generated from the sale of the call are enough to offset the cost of the put.

Let's take a look at how the strategy works with this position. For the sake of our illustration and to make our calculations easy, let's establish the collar using the December $27.5 put and the December $30 call, with both trading at $1.00.

Remember our stock price was $28.50. The cost of the collar will be zero because you paid $1.00 for the put but you collected $1.00 from the sale of the call. How does the collar work in our usual three scenarios: the "up" scenario, the "down" scenario and the "stagnant" scenario?

The "Up" Scenario

In the "up" scenario, we find that when the stock rises, the investor gains penny for penny until the stock reaches the call strike. Once the stock reaches that level, the position no longer gains because the stock is at the point where it will be called away.

Capital gains of the position are maximized when the stock reaches the call's strike price. Let's take a closer look at what happens as the stock price goes up. With the stock at $29.00, both the Dec. $30 calls and the Dec. $27.5 puts are out-of-the-money and thus worthless. Since there was no debit or credit incurred in the options, the option profit (loss) is zero. Only the stock position remains. The stock purchased at $28.50 is now trading at $29.00 for a 50-cent profit.

Let's raise the stock price to $30.00. The puts and calls are again worthless so your profit (loss) is solely determined by the stock. The stock, which was purchased for $28.50 is now worth $30.00 and represents a gain of $1.50. This $1.50 gain is the maximum gain the position allows.

Once the stock goes over $30.00, the Dec. 30 call, which we are short, would become in-the-money and therefore the stock position would be called away at that price. When the stock price rises to $31.00, the puts would be out-of-the-money thus worthless but the calls would be worth $1.00.

You received no money for the establishment of the collar so you would have a $1.00 loss in the options. Meanwhile, the stock that you purchased at$ 28.50 is now worth $31.00 at expiration, which is a $2.50 gain.

Combine the $2.50 gain in the stock with the $1.00 options loss; you have a $1.50 profit again. You may do this calculation with higher and higher stock prices but the outcome will always be the same. This example shows how your upside potential is limited.

Obviously, if the option portion of the collar incurred a debit or credit, that inflow or outflow of money must be added to or subtracted from the stock gain to get the overall return of the position.

Normally, there will be a debit or credit incurred in the collar since it is usually difficult to find a put and a call that you want to use in the collar trading at an equal value. Let's use our last example with some minor price changes.

If the put had been trading at $1.25 instead of $1.00, then there would be a $.25 capital outflow that would have to be subtracted from the $1.50 gain to reduce it to only a $1.25 gain.

On the other hand, if the call was trading at $1.25 then you would have collected an extra $ .25 which added to the $1.50 gain would produce a $1.75 gain. The cost of the collar always impacts the bottom line profit or loss of the position.

Looking at the collar in the "stagnant" scenario, the stock price would be unchanged thus neutral in terms of return. Therefore, the potential profit or loss would come strictly from the debit or credit of the two options.

If the stock does not move, as in our example, both the put and call would finish out-of-the-money and be worthless.

Our profit or loss would simply be calculated from whether you paid for the collar or collected from the collar and by the amount of that debit or credit.

Using the same prices as the previous example (the stock purchase price of $28.00, the Dec. 27.5 put $1.00 and the Dec 30 call $1.00) we will now take a look at the "down" scenario. Let's set the stock price at $28.00 on expiration.

The "Down" Scenario

At this price both the Dec. 27.5 put and the Dec. 30 call are out-of-the money and worthless. Since there is no credit or debit incurred in the option position ($1.00 inflow from the calls, $1.00 outflow from puts) the total return of the position is simply the gain or loss from the stock.

With the stock purchase price of $28.50 and a stock price of $28.00 on expiration, there will be a $ .50 loss in the position. Setting the stock price at $27.50, we see that the Dec. $27.50 puts and the Dec. $30 calls are again worthless and with no debit or credit incurred, the positions profit or loss will come down to the gain or loss on the stock.

With the purchase price of the stock being $28.50 and the stock price at expiration $27.50, there will be a $1.00 loss. In this case, we have reached the maximum loss. No matter how low the stock goes, you can only incur a maximum loss of $1.00.

Now, let's set the stock price at $26.00 and see if this holds true. With the stock at $26.00 on expiration, the Dec. $30 calls are out-of-the-money and worthless. The Dec. $27.5 puts, however, are in-the-money and now worth $1.50.

The stock you purchased for $28.50 is now worth $26.00 on expiration which is a $2.50 loss. Combining the $2.50 stock loss with the $1.50 gain in the puts and you have a $1.00 loss in the overall position.

This demonstrates that $1.00 is the maximum loss of the position. Keep in mind that if the stock position creates a debit or a credit, it must be added to, or subtracted from the stock loss.

Most of the time, there will be a small debit or credit incurred in the option position. It is relatively infrequent that the put and call used in the collar are trading at the exact same price.

Collar Example Return Table
Stock Price	Stock P & L	Option P & L	Total P & L
32.00	+3.50	-2.00	+1.50
31.50	+3.00	-1.50	+1.50
31.00	+2.50	-1.00	+1.50
30.50	+2.00	- .50	+1.50
30.00	+1.50	0	+1.50
29.50	+1.00	0	+1.00
29.00	+ .50	0	+ .50
28.50	0	0	0
28.00	- .50	0	- .50
27.50	-1.00	0	-1.00
27.00	-1.50	+ .50	-1.00
26.50	-2.00	+1.00	-1.00
26.00	-2.50	+1.50	-1.00

Like other strategies, the collar can be leaned toward the investor's perception of the stock's direction and strength.

Let's look at the potential leans that can be taken. Say that you have a very strong feeling the XYZ is going to go up. Instead of buying a put and selling a call with strikes that are roughly equidistant from the stock price, you would sell a call that is further out-of-the-money.

This would allow more room for a larger increase in stock price because the stock would not be called away as early. You retain ownership for a longer period of time during the increasing price period.

Of course, by increasing the distance of the option's strike away from the stock, the amount of the call's premium will decrease. The overall effect is that you'll have to pay more to own the position. (You will pay out more money for the put than you will receive from the call.)

Again, we'll start with the same prices as in our original case, (stock $28.00, Dec. 27.5 put $1.00 and Dec. 30 call $1.00) only now we will change the $Dec. 30 call at $1.00 to the Dec. $32.5 call at 35 cents.

In our other examples, we incurred no debit or credit from our option position. This time, with the bullish lean, a debit is incurred. The purchase of the Dec. $27.5 put for $1.00 combined with the receipt of 35 cents from the sale of the Dec. $32.5 call produces a 65-cent debit.

Remember, this debit must be subtracted from the bottom line profit or added to the bottom line loss of the stock's capital result. This means that before you make any money from the position, the stock must trade up 65 cents.

If the stock stays stagnant you will lose 65 cents and any capital loss you incur will be 65 cents worse. Now back to the position in our previous example. With the selling of the Dec. $30 call, we had an upside potential of $1.50. In this example things change.

As was stated, our maximum upside potential is calculated by setting the stock price at the strike price of the short call which is $32.5 in this case. With the stock at $32.50 at expiration, you would have a $4.00 stock gain since the stock was purchased for $28.50.

Remembering your 65-cent debit to enter the position, we subtract that from the $4.00 and we have a total maximum profit of $3.35. This is significantly more potential reward than our original example using the Dec. $30 call.

As in all trading situations that offer a higher potential reward, there comes a higher potential risk. If the stock stays at $28.50, (the stagnant scenario) you have a loss of 65 cents in option costs.

In the down "scenario," calculating the maximum risk is done by setting the stock price at $27.50 on expiration.

The stock, purchased at $28.50 has lost $1.00. The options, not neutral, resulted in a 65-cent loss. The total loss is $1.65. In both the "stagnant" and "down" scenarios, the loss increased over that in our original example. As you can see, the higher potential gain is accompanied by an increased potential risk.

Key Point -- The collar strategy allows for a limited but continued capital appreciation of a long stock position while providing for a limited, fixed downside exposure. The position is very inexpensive to initiate due to the offsetting premiums of the long (purchased) put and short (sold) call.

The collar is an excellent protective strategy for an investor who has a bullish opinion on a stock.

In looking at the bullish lean example, one of the flaws is the fact that if you move that upside call to the higher strikes you may overly decrease the amount of premium you receive for the sale of that call which, as you know, is supposed to compensate for the amount spent on your protective put.

One way to adjust for this is to look further out across the months in the strike you are interested in. Selling a call out two or three months may generate enough premiums to fully offset the price of the put.

Remember, premiums increase over time for all options. You do not have to be confined by the idea that your long put and short call have to be in the same expiration month.

This adjustment provides more acceptable premium balance allowing extra room for a strong upward stock move while still giving you maximum downside protection.

Now let's look at some examples.

LLY Chart -- Collar Example #1

Source: Quote.com^®

NOTES ON ELI LILLY (LLY) -- Collar Strategy

1. In a one month span from Nov. 18, 2002 to Dec. 18, 2002 LLY traded from just below $60.00 to just below $70.00 and back down to $62.00.

2. In another one month span from late May 2003 to mid-June 2003, LLY traded from $56.00 up to $72.00.

3. Several gap openings are also apparent with one in mid-January 2003, one in late August and one in very late September. These all point to periods of high or increasing volatility.

4. We also want to notice the individual daily trading ranges. The length of the lines shows the number of large range days. The longer lines indicate larger intraday ranges. In the chart above, LLY shows a very high number of large intraday movement days, again pointing to high volatility.

5. As much as LLY had strong run-ups, it had some large down periods also. In a two-month period from mid-January to mid-March 2003, LLY traded down from $68.50 to $58.00. Then in another two month period, mid-June to mid August 2003, LLY traded down from $71.00 to $61.00.

Conclusion: LLY appears to be a very volatile stock during the observed period charted above. The stock began this period at around $60.00 and finished the period at $67.00, which is not necessarily a large move. But when we look at the large intra-month ranges, it's clear that LLY has been very volatile during this period.

With this type of movement, a maximum protection strategy is necessary but, with such high volatility, premiums will likely be expensive. The outright buying of a put may cut too deeply into potential profits making the risk reward scenario unjustified.

The collar strategy, however, will provide the necessary downside protection, while still allowing room for some capital appreciation. The sale of the call will offset the cost of the put purchase to make the trade's risk/reward scenario more viable. The collar can be leaned to provide either more protection or more capital appreciation, depending on the investor's short term outlook.

EBAY Chart -- Collar Example #2

Source: Quote.com^®

NOTES ON EBAY (EBAY) -- Collar Strategy

1. Ebay traded in a very wide range during July 2003. It started the month around $51.50 and traded up to $57.50 before trading down to $54.40. Within a week it traded to a high of $59.00. The week after that, the end of the month, the stock was down to $52.50.

2. August was another volatile month. The stock had a high of $57.25 and a low of $50.

3. The stock started the month of September trading at $56.50. It traded down to $50.50 then back up to $57.

4. Volatility continued in October. The stock had quite a range with a high of $61.50 and a low of $53.50. Moreover, the stock had no less than five gap openings. The gap openings were almost evenly divided between "ups" and "downs."

5. The pattern continued in November 2003. The stock started the month by quickly putting in a high around $58.50. It then traded down, reaching a low around $50.75, before rallying and trading back up to $57 before the month's end.

6. December began with the stock trading around $57. It then moved down quietly to $55 by the middle of the month. By the end of the month, eBay was trading at $64.00, up an astounding $9 in a little more than two weeks.

Conclusion: A stock this volatile needs a hedging strategy that provides maximum protection. A covered call strategy will provide some protection but not enough for a stock with the month in and month out volatility that eBay exhibits.

The protective put strategy would work in terms of maximum downside protection, but at what cost? With volatility this high, the puts will be very expensive, maybe too expensive. This situation is perfect for employing the collar.

The sale of a call against the purchase of the put will at least partially offset the expense of the put, making the downside maximum protection affordable, while still leaving room for capital appreciation.

YHOO Chart -- Collar Example #3

Source: Quote.com^®

Notes on Yahoo (YHOO) -- Collar Strategy

1) Yahoo, a historically volatile stock, bottoms out and then trades through resistance of a downtrend in mid-August 2003.

2) Yahoo then trades in an uptrend from a price around $33.00 in late August out through January 2004 with a price high of $46. This represents a 40% increase in just four months.

3) During this uptrend, Yahoo had several gap openings which are considered very volatile events. There are three of these gaps in October 2003 and two in November 2003.

4) Further, Yahoo has many large intraday range days. This also points to a higher level of volatility for this stock.

5) This uptrend that Yahoo trades in has a wide range. The stock fluctuates widely from the mid-line of the range. Again, indicative of higher volatility.

Conclusion: Yahoo offers the investor a good upside opportunity. However, in a stock as volatile as Yahoo, there is also large potential for loss also.

Here, a maximum protection strategy is advised. Under these higher volatility situations, the collar would be better than the protective put because of overall cost.

When trading a stock with such high volatility, the investor must be aware that option premiums will be expensive if not prohibitive. The collar gives the investor the needed downside protection at a much lower cost (due to premiums received from the sale of the call) while still allowing room for capital appreciation.

MER Chart -- Collar Example #4

Source: Quote.com^®

Notes on Merrill Lynch (MER) -- Collar Strategy

1) During this viewing period, Merrill trades in an uptrend from late June 2003 at a price of about $45 through January 2004 with a high around $60.

2) This is a wide trend with some intra-month ranges as much as $5 and $6 wide, indicating a volatile trend.

3) There were a few gap openings early on in the uptrend during July, but we also want to look at the large intra-day ranges, displayed by the length of the daily candles.

4) The stock also deviates frequently from the mid-line of the trend and although it stays within the trading channel nicely, this still is a volatile trading pattern.

Conclusion: With volatility high, option premiums will probably be expensive. In Merrill's case, the investors should look to obtain maximum protection, but the protective put would not be the best choice.

Although the stock is very volatile, the uptrend is not a steep one. During the observed period of six months, the trends mid-line capital appreciation is only a little more than $6, not much compared to many other stocks during this period. With the high volatility, the price of a protective put for any length of time would quickly eat away any profits from the stock's rise.

A collar would allow the investor the protection needed, at a reasonable and warranted cost, to justify the potential reward of the capital appreciation.

Many times you may be holding a stock that you feel will increase in value in future but are not sure when. If the stock is extremely volatile, the waiting for that big move presents quite a risk. The gut-wrenching ups and downs even intra-day may be more than most conservative investors could handle. Thus, you pass on the opportunity only to find that months or years later you were correct -- but have nothing to show for it. The collar strategy allows you to enter into these high volatility gut-wrenching opportunities without subjecting you to these scary moments. Let us show you how and when to collar these opportunities for profits you may have otherwise missed.