Options Collar Strategy

  • November 18, 2020

Have you considered hedging a long term investment through impending volatility? Weather you are investing  in a position for dividends or growth you'll eventually come to discover a need for a hedge strategy. Enter the options collar strategy.

Options are a great way to make money trading large cap stocks. All while saving a little money. However, it's not as magical as it seems. Options are wasting assets. As a result, you need to know how to properly trade them.

Options Collar Strategy

  • There are many ways to hedge a position. For example, you could pay some premium to buy a protective put. You could sell a covered call. In fact, you could even buy an equivalent value of an inverse ETF in the sector that your position is in. You could do any of these and more for a price but what if you could hedge your position with a known limited loss like a protective put but you also receive a credit?

Sounds too good to be true right? Well it is true, the only catch is that you will need to learn a little bit about options and how they can work for you first.

We will start with the basics. Options trading for dummies part 1 if you will. Understanding the moving parts helps immensely. 

Options Collar Strategy

1. Call Options

The call option. A call option is a contract with a specific expiration date and a specific strike price. The contract gives the buyer the option but not the obligation to buy 100 shares of the specified stock at the strike price on or before the expiration date. As a result, the buyer pays a premium to the seller for the contract.

A call option contract originator (seller) is obligated to sell 100 shares of the specified stock at the strike price at any time on or before the expiration date.

The option seller is paid a premium by the buyer for the contract. So how do call options make up the options collar strategy? Read on.

2. Put Options

A put option is a contract with a specific expiration date and a specific strike price. The contract gives the buyer the option but not the obligation to sell 100 shares of the specified stock at the strike price on or before the expiration date.

As a result, the buyer pays a premium to the seller for the contract. A put option contract originator (seller) is obligated to buy 100 shares of the specified stock at the strike price at any time on or before the expiration date.

Therefore, the option seller is paid a premium by the buyer for the contract. Are puts apart of the options collar strategy? We'll dive into that more later.

Both put and call options can be traded by both the originator (writer) and the buyer at any time before the expiration date. That means that you can write options and then buy them back at any time.

A trader or investor who is long an option will buy to open a position and sell to close a position. A trader or investor who is short an option will sell to open a position and buy to close a position.

Selling short options result in a credit to your account and buying long options result in a debit to your account.

3. Options Lingo to Understand

Call options with strikes that are below the current share price are "in the money". Call options that are just above or equal to the share price are "at the money".

And call options that are a strike or more above the share price are "out of the money". They're abbreviated as ITM, ATM and OTM.

Put options with strikes that are above the current share price are "in the money". Put options that are equal to or one strike below the share price are "at the money".

And put options that are one strike or more below the share price are "out of the money". Same abbreviation ITM, ATM and OTM.

Short options are known as "sell to open" or STO. Closing a short option requires buying the option back and known as "buy to close" or BTC.

On the contrary long options are known as "buy to open" or BTO and closed when sold or "sell to close" STC.

Got the basics down? Good, now we can get to the meat and potatoes.

What is an Options Collar Strategy?

  • The options collar strategy is simply selling to open an out of the money covered call for every 100 shares of held stock while buying an out of the money protective put option with the same expiration date as the call. Both options are out of the money but the spread between the strikes and the number of strikes out of the money will determine whether you enter a net debit or net credit position.

One would prefer to enter a net credit position. However, it really depends on the cost basis of your long stock position and how much you are willing to lose if selling your position by exercising your put option(s) to protect your capital.

Or how much profit you are comfortable making on your long position if your short call option(s) are exercised. In either case, a net credit will either offset some losses or bolster some profits.

To enter the collar with a credit you'll likely have to sell the call a strike or two closer to the money than the long put. This is because puts are usually a little more expensive than calls. 

The put seller must assume more risk than a call seller. As a result, the premium for puts will always be somewhat greater than the premium for calls.

If your cost basis on your long stock position is between the two strikes and close to the current share price, your hedge in the collar strategy should have a maximum loss that's within your risk tolerance from your initial trading plan.

However there is a bit of a drawback. If you're assigned on the covered call(s) your profits will be limited.

1. Likely Scenarios of a Successful Collar Strategy

In an ideal situation the expected volatility you are hedging against passes and the share price stays within your strikes in the spread. Often times when this happens you can close the position with a small profit and keep your long stock position.

In a worse case scenario you are assigned on your covered call and your long put expires worthless. Although you received a net credit when opening the position, you'll want to close your long put to preserve as much credit as you can. You still win in the worst case scenario because you get to exit the trade with profit.

Here is the situation where the hedge does its job. The share price tanks far below your long put(s) and you are forced to exorcise it before expiration. CLOSE THE COVERED CALL(S) FIRST!!!

This will protect you from entering a short position with unlimited risk. If you were to exercise your put(s) without closing the covered call first, you'll have a naked call.

If the share price were to bounce back right after you exercised the put(s) and go above the strike price of the call(s) you'll experience loss because you'll no longer have shares on hand to cover call assignment.

You could also just let the options expire. Most brokers will exercise the put(s) for you and close the call(s).But definitely read their policy to know for sure.

It's also a good idea to open the collar strategy with an expiration date at least one month out beyond the expected volatility event. This will make early assignment on your short option(s) much less likely. It's not necessary to have expiration much further than that unless you're expecting a longer period of volatility.

2. A Few Takeaways

  1. The objective is to hedge against volatility.
  2. The options collar strategy does potentially limit your profit on your position while hedging potential losses.
  3. Early assignment can happen on a short option. Be prepared to take action and close your long option.
  4. It's important to manage the collar strategy. It is not necessarily a set it and forget it position.
  5. It's also important to practice paper trading the strategy to understand how to manage it before you use it in your live position.

Options Collar Strategy Final Thoughts

One of my favorite things about options is their ability to make money in any market. As a result, there's always a way to make money. Even with the market trading sideways.

An options collar strategy is just another way for you to make a profit. Practice trading them before using real money! The best broker for options trading will allow that.

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