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Creating A Collar

  • A collar is an options strategy that protects against significant losses while still allowing for upside potential. To create a basic collar you need to hold the underlying stock, buy a protective put option and sell a call option:
  • Hold the underlying stockFirst, you need to own shares of the stock you want to protect. The number of shares you own will determine the number of options contracts you will use since each options contract typically represents 100 shares.
  • Buy a Protective Put OptionA put option gives you the right to sell your stock at a specified price (strike price) within a certain time frame. This protects you from a drop in the stock price below the put’s strike price. When selecting a put option choose a strike price at or below the current stock price. This is the price at which you can sell your stock.
  • Sell a Call OptionA call option gives the buyer the right to purchase your stock at a specified price (strike price) within a certain time frame. By selling a call, you generate income, which can help offset the cost of buying the put. When selecting a call option choose a strike price above the current stock price. This is the price at which you must sell your stock if the option is exercised.
  • Let’s assume you own 100 shares of XYZ stock currently trading at $50 per share.
  • Buy a Put Option:

Strike Price: $45 (you are protected below this price) Expiration: 3 months from now Cost: $2 per share (total cost = $2 * 100 shares = $200)

  • Strike Price: $45 (you are protected below this price)
  • Expiration: 3 months from now
  • Cost: $2 per share (total cost = $2 * 100 shares = $200)
  • Sell a Call Option:

Strike Price: $55 (you agree to sell your shares at this price if exercised) Expiration: 3 months from now Premium received: $1.50 per share (total premium = $1.50 * 100 shares = $150)

  • Strike Price: $55 (you agree to sell your shares at this price if exercised)
  • Expiration: 3 months from now
  • Premium received: $1.50 per share (total premium = $1.50 * 100 shares = $150)
  • Cost of Put Option: $200
  • Premium from Call Option: $150
  • Net Cost: $200 – $150 = $50
  • Stock Price Drops Below $45:

The put option will protect you from further losses below $45. You can sell your shares at $45. The call option will expire worthless.

  • The put option will protect you from further losses below $45. You can sell your shares at $45.
  • The call option will expire worthless.
  • Stock Price Between $45 and $55:

You retain your shares and do not need to exercise the put option. The call option will expire worthless, and you keep the premium received from selling the call.

  • You retain your shares and do not need to exercise the put option.
  • The call option will expire worthless, and you keep the premium received from selling the call.
  • Stock Price Rises Above $55:

Your stock will be called away at $55 per share. You still benefit from the appreciation of the stock up to $55 plus the premium received from selling the call option. The put option will expire worthless.

  • Your stock will be called away at $55 per share.
  • You still benefit from the appreciation of the stock up to $55 plus the premium received from selling the call option.
  • The put option will expire worthless.