What is a Collar Option Strategy in Stock Options?

Collar Option Strategy

A collar option strategy is created to diminish both positive and negative returns of the underlying assets. It can hedge the options against the volatility of the market and limit the return of a portfolio within a specified range.

To do this, a protective put and a covered call option are used. Generally, it is created by holding an underlying stock, buying out-of-the-money put options, and selling an out-of-the-money call option.

How does a Collar Option Strategy work?

A collar option strategy is used to limit both upside and downside of an investment. It involves a long position on an underlying stock, a long position on the out-of-the-money put, and a short position on an out-of-the-money call.

  • In a long position on the underlying stock, the trader will profit if the price increases. If the price goes down, the trader will incur a loss, but the loss is neutralized by the long put. It happens because when the strike price of the underlying asset decreases, the value of the put option becomes more profitable.

  • The trader will also utilize a short out-of-the-money call to neutralize the profits from the put option. As the strike price of the underlying asset increases, the call option provides the trader a loss. This potential loss neutralizes the potential upside of the deal.

The value of the portfolio is equal to the value of the underlying asset between the strike price of the put and call options. The loss incurred due to the call option being above the strike price will cancel the gains from appreciation of this. Therefore, the payoff will essentially be flat. The gain for the strike price is below the strike of the put will cancel the losses for depreciation. So, the payoff will be flat here too.

Collar as a Hedging Option

The collar is usually used as a hedging option.

  • If the long position is held by the investor, they can create a collar strategy to get relief from large losses. If the price of the underlying asset goes down considerably, the protective put option can be used.

  • A covered call option is sold in order to pay for the loss in the protective put strategy and it will still allow for the potential upside movement of the underlying up to call’s the strike price.

  • If a stock has good long-term gains but losses in the near term, a collar strategy can be used. If a long underlying has high market value, a collar can be used to gain from the high market value of the underlying asset.

  • Finally, collars are also used in Mergers and Acquisitions to determine the real position and value of a stock deal.

Updated on: 27-Oct-2021


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