This is a good strategy to use when an investor is mildly bullish on a stock but also wants to protect against a downside move in the stock’s price. By reading this article, investors will gain a better understanding of how to effectively use this strategy to generate a profit.
In this strategy, selling the “out-of-the-money” call option produces an income that allows for the purchase of the “out-of-the-money” put option. If the stock’s price decreases, then the put option protects the investor from loss. If the stock’s price increases, then the call option allows the investor to profit on the stock up to the strike price point but not higher.
The collar strategy protects investors from big losses but also prevents investors from big returns. Because of this reason, investors who are very bullish on a stock would not want to use this strategy.
The maximum profit is equal to the call option’s strike price minus the underlying stock’s purchase price per share. Afterwards, the cost of the options, whether for credit or debit, are factored in. The maximum loss is equal to the underlying stock’s purchase price minus the put option’s strike price. Again, the cost of the options are factored in.
Assume an investor owns 500 shares of stock XYZ that he bought at a price of $100. Currently, the stock is trading at $95. To protect against further downside risk, the investor sets up a collar strategy by purchasing 5 put options with a strike price of $93 and selling 5 call options with a strike price of $103.
Assume the call options were sold at a premium price of $3 per share. Assume the put options were bought at a premium price of $5 per share. Therefore, the investor enters the trade with a net debit of $2 per share.
If the stock expires at $103 or above, then the investor will achieve the maximum profit of $500, or 5 contracts x 100 shares per contract x (103 – 100 – 2).
If the stock expires at $93 or below, then the investor will experience his maximum loss of $4,500, or 5 contracts x 100 shares per contract x (100 – 93 + 2).
By looking at this example, an investor can see how there is a chance to achieve a profit but also a heavy loss when using this strategy. Therefore, this strategy should only be used when an investor is confident that a stock will be mildly bullish in the near future. If an investor is mildly bullish on a stock, then this strategy is a great tool to protect against possible downside risk.