The Collar Strategy

[Igor 10]

Traders who implement the collar strategy are betting that the market price will go up for the assets owned in their portfolio. The technique involves buying put options and writing (selling) the same amount of call options for the identical underlying asset. Traders use this method to protect their long position from a bear market. The potential profit and the potential loss are limited when entering this type of position.

 

The Differences Between ITM, ATM and OTM for Puts and Calls

There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing the collar strategy.

 

Put Options:

ITM - In The Money: The underlying asset's market price is less than option's strike price.

OTM - Out of The Money: The underlying asset's market price is more than option's strike price.

 

Call Options:

ITM - In The Money: The underlying asset's market price is more than option's strike price.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

 

Both Put and Call Options

ATM - At The Money: The underlying asset's market price equals the option's strike price.

 

How to Implement The Collar Strategy (OTM)

 

 

XYZ is worth $48 (market price)

1) Trader buys 100 shares of XYZ preferred stock and pays $4800.

2) Trader writes (sells) a call option: XYZJul50($2)

- 100 shares of XYZ stock

- Strike Price $50 (OTM), expiring in 30 days

- Premium Cost of $2

3) Trader buys a put option: XYZJul45($1)

- 100 shares of XYZ stock

- Strike Price $45 (OTM), expiring in 30 days

- Premium Cost of $1

4) Trader receives a total credit of $100 in premiums [($200 (received from the call) - $100 (paid for the put)]

Total Investment cost: $4700 [$4800 (paid) - $100 (premium credit)]

 

Result one: XYZ hits $53

a) The put option expires worthless (OTM).

b) The call option is ITM. The call buyer exercises his or her right to buy the writer's 100 shares at $50, and pays $5000 to the trader.

c) The trader makes a total profit of $300 after subtracting the total investment cost from the profit made on the call. [$300 = $5000 (profit from call) - $4700 (cost of investment)]

 

Result two: XYZ hits $43

a) The call option expires worthless (OTM).

b) The put option is ITM. The trader exercises his or her right to sell 100 shares at $45 and receives $4500 his or her shares.

c) The trader loses a total of $200 after adding after subtracting the total investment cost from the sale of the shares. [-$200 = $4500 (received from put) - $4700 (cost of investment)]

 

Result three: XYZ hits $48

a) The put option expires worthless (OTM).

b) The call option expires worthless (ATM).

c) The trader makes a total profit of $100 after keeping the premium credit from the call and the put options.

 

Advantage and Disadvantage of Implementing The Collar Strategy:

 

Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using the collar strategy is that the trader also knows exactly how much he or she would lose if the market declines, since their loss risk is also limited by the terms of the put option.

 

Minuses: The downside in using covered combination strategy is that the method limits an investor's profits. If the underlying asset's market value explodes, the trader would only receive what he or she gains from the call option.