Collar Strategy

Overview

A collar is similar to Covered Call but involves another leg—buying a Put to insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a Collar is buying a stock, insuring against the downside by buying a Put and then financing (partly) the Put by selling a Call.

The put generally is ATM and the call is OTM having the same expiration month and must be equal in number of shares. This is a low risk strategy since the Put prevents downside risk. However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be adopted when the investor is conservatively bullish. The following example should make Collar easier to understand.

When to use: The collar is a good strategy to use if the investor is writing covers calls to earn premiums but wishes to protect himself from an unexpected sharp drop in the price of the underlying security.

Risk: Limited

Reward: Limited

Breakeven: Purchase Price of Underlying—Call Premium + Put Premium

Example

1. If the price of ABC Ltd. rises to Rs. 5100 after a month, then,

• Mr. A will sell the stock at Rs. 5100 earning him a profit of Rs. 342 (Rs. 5100—Rs. 4758)
•         Mr. A will get exercised on the Call sold and will have to pay Rs. 100.
•         The Put will expire worthless.
•           Net premium received for the Collar is Rs. 12.
•         Adding (a +b+d)= Rs. 342—100—12= Rs. 254

This the maximum return on the Collar Strategy

However, unlike a Covered Call, the downside risk here is also limited:

2) If the price of ABC Ltd. falls to Rs. 4400 after a month, then,

•     Mr. A loses Rs. 358 on the stock ABC Ltd.
•     The Call expires worthless
•     The Put can be exercised by Mr. A and he will earn Rs. 300
•     Net premium received for the Collar is Rs. 12
•     Adding (a+b+d)= —Rs. 358+ 300 +12= —Rs. 46

This is the maximum the investor can loose on the Collar Strategy. The Upside in this case is much more than the downside risk.

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