Chapter 3

Equity Collar Strategy

In the last two chapters, we’ve discussed covered calls and protective put option strategies. These equity and option combination strategies accomplish two different purposes: one is to earn additional yield on the owned stock and one is to mitigate downside risk of the owned stock. There are trade-offs to both of these strategies.

For the covered call, we earn additional yield but this is at the risk of potentially missing out on upside gain of the stock. We would miss out on the gain if the stock price closes above the strike price of the shorted call option. 

For the protective put strategy, we have a hedge against losses due to the stock price going down but to continually buy put options can lead to underperformance when the stock is on an upward trend.

What is a Collar strategy?

Since selling calls and buying puts have two different purposes, is selling a call option and buying a put option on a stock that we own a viable strategy? Yes, it is. This strategy is known as a ‘Collar’. Selling a call option earns us a premium that can offset the cost of buying the put option. 

Constructing a Collar strategy

Let’s look at the data in illustration 1 below. Assume that the underlying stock is trading at 395 and we decide to implement a collar with a put option at the 385-strike price and call option at the 405-strike price. 

The cost to buy the put option is 3.06 and the premium we receive from selling the call option is 2.18. The net cost to execute the collar in this example is -0.88. By implementing the collar, we may ‘give up’ some or all of the yield we receive to purchase the downside protection of the put option.

Illustration 1

What is the maximum upside of a Collar?

The maximum upside of a collar is similar to a covered call. In our example using the data from illustration 1, our maximum upside is capped at the shorted call strike of 405. 

Since we paid a net 0.88 to enter into the Collar, the max upside is the difference between the shorted call strike and the underlying purchase price minus the cost to enter the Collar. 

One note is that you don’t always pay to enter a Collar; you can enter into a zero-cost Collar or even one that still provides a net premium. Using illustration 1, if the trader decided to short the 400-strike call while still purchasing the 385-strike put, this will result in a net premium to the trader. The shorted call will yield a premium of 3.94 and the put option will cost 3.06. The net premium will be +0.88. 

The general formula for the maximum gain of a collar is:

Key Formulae

Collar Maximum Gain = Strike Price of Short Call – Underlying Stock Purchase Price – Net Cost (or + Credit) of Strategy 

The challenge with a collar’s upside is the same as with a covered call. If the underlying stock is performing well and moves significantly above the shorted call’s strike price, then the trader won’t participate in these gains in the underlying stock. The gain in the underlying stock will be offset by the loss of the shorted call option above the strike price.

What is the maximum loss of a Collar? 

The maximum loss of a collar is similar to that of the protective put strategy. The losses of the underlying stock are limited to the put option’s strike. Using illustration 1, if we purchase a put option as part of our collar that has a strike price of 385, then the most that our strategy can lose is the difference between the put option strike and the purchase price of the underlying stock minus the cost to enter the Collar.

Key Formulae

Collar Maximum Loss = Strike Price of Put Option – Underlying Stock Purchase Price – Net Cost (or + Credit) of Strategy 

The profit diagram of the Collar is seen in illustration 2 below.

Illustration 2

How does this strategy compare to only owning the stock?

Using the same example data from Tata Motors that we used in the Covered Call and Protective Put chapters, we can assess the Collar strategy. 

• In row one, we list the monthly returns of owning Tata Motors. 
• In row two, we list the hypothetical returns of the Collar. 
• In this collar, we are purchasing a put on a monthly basis at 10% below the current price of Tata Motors. On the same day and also on a monthly basis, we are selling a call option that is 5% above the current price of Tata Motors. Each month, we are virtually holding the shorted call option until expiration. For the purchased put option, we are holding the option until expiration unless it has a positive intrinsic value at some point during its life. This means that the underlying stock would be at or below the put option strike price prior to expiration. This early exit of the put option occurs three times during our backtest: June, May, and March. We highlight the dates of early exit in blue. 
• The third row displays the benefit of the Collar versus only holding the Tata Motors. The Collar outperforms in every month except for in July and October. In these two months, the returns of Tata Motors are 7.2% and 44.3% respectively. Since these returns are higher than the 5% out-of-the-money shorted call strike, we would have lost out on this upside.

Illustration 3

To conclude:

• A collar strategy involves selling a call option and buying a put option on a stock that we own.
• The premium from the call option offsets the cost of buying the put option.
• One might have to ‘give up’ some of the yield to purchase the downside protection of the put option. 
• Maximum upside is capped at the shorted call strike price.
• You can enter into a zero-cost Collar or one that provides a net premium.

Key Formulae

• Collar Maximum Gain = Strike Price of Short Call – Underlying Stock Purchase Price – Net Cost (or + Credit) of Strategy 
• Collar Maximum Loss = Strike Price of Put Option – Underlying Stock Purchase Price – Net Cost (or + Credit) of Strategy 

Overall, the Collar is a way to smooth out stock returns. In the long run, you likely won’t outperform holding the stock by itself due to missing large upswings. However, the Collar is a reasonable trading strategy for someone that is risk averse or may be concerned about negative returns in the near-term.

With that, we have completed Equity & Option Combination Strategies module. Don’t forget to keep flexing your ‘options’ muscles (even if it is on paper only). Practice is what will help you master these strategies.