A collar is a name given to an investment strategy that uses options in order to limit the range of possible positive or negative returns on an investment in an asset to a specific range. For having this done, an investor by whom an asset is owned simultaneously buys a put option and sells (writes) a call option on the same asset. It is needed that the strike price on the call should be above the strike price for the put, and the expiration dates should be the same.

After that the investor has established the portfolio in this manner, the market value of the portfolio will be between the strike price on the call and the strike price on the put. Thus doing this possible gains and losses (the value of the portfolio minus the cost of acquiring it) are confined within a specified range.

Example

Let us consider an investor by whom one share of a stock is owned with a current price of $5. A collar could be constructed by an investor by buying one put with a strike price of $3 and selling one call with a strike price of $7. It will be ensured by the collar that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option, i.e., the cost of the put option minus what is received for selling the call option).

3 Possible Scenarios for Expiry of Options

For the expiry of options there are three possible scenarios:

1st Scenario:

If the stock price is above the $7 strike price on the call that has been written by him, then the person who bought the call from the investor will exercise the purchased call; it will be required for the investor to sell the shares at the $7 strike price. Doing this $2 profit would lock in for the investor. Only $2 profit will be made by him, no matter how high the share price goes.

2nd Scenario:

If the stock price falls below the $3 strike price on the put then the put will be exercised by the investor and the person who sold it is forced to buy the investor’s share at $3. Only $2 would be lost by the investor on the stock, but he can only lose $2, no matter how low the price of the stock goes.

3rd Scenario:

If at the expiration date the stock price is between the two strike prices, then both options expire unexercised, and the investor is left with the share whose value is that stock price, in addition to that he will also have the cash premium from the sale of the call option.

Why to Construct a Collar?

In times of high volatility, or in bear markets, it might be useful for the investors to limit the downside risk to a portfolio. One obvious way for doing this is to sell the stock. In the above example, if just that the stock is sold by an investor, then the investor would get $5. May be it is fine, but it have some additional questions. Does the investor has got an acceptable investment available to put the money from the sale into? What are the transaction costs that are associated with liquidating the portfolio? Would it be possible for the investor to just hold onto the stock? What will be the tax consequences?

Limit the Downside Risks

If it makes more sense to hold on to the stock (or other underlying asset), then possibly the investor is able to limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage of setting a collar is that usually the cost of setting up a collar is free or nearly free. The price that is received is used for selling the call in order to buy the put, means one pays for the other.

Definite Returns

Finally, by using a collar strategy the investors takes the return from the probable to the definite. What it means is that, when a stock is owned by an investor (or another underlying asset) and it has an expected return, then that expected return is only the mean of the distribution of possible returns, that is weighted by their probability. May be a higher or lower return is received by the investor. When a collar strategy is used by an investor by whom a stock (or other underlying asset) is owned, then it is known by the investor that the return can be no higher than the return that is defined by strike price on the call, and it will be no lower than the return that results from the strike price of the put.

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