How a Protective Collar Works

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How a Protective Collar Works

When the markets begin to fluctuate violently, investors frequently flee for safety since volatility instills anxiety in market participants. But there’s no need to worry! A protective collar is an options strategy that may give short-term downside protection, providing a cost-effective approach to safeguard against losses while still enabling you to profit when the market rises. The mechanics of launching this hedging strategy are covered in this section.

Key Takeaways

  • A collar is an options strategy that is used to protect against excessive losses while also limiting profits.
  • The protective collar technique consists of two strategies: a protected put and a covered call.
  • The overall cost of implementing this technique might be fairly modest since you are selling one option to finance the acquisition of another.

The Protective Collar Strategy

A protective collar consists of:

  1. an investment in the underlying securities
  2. a put option acquired to hedge a stock’s downside risk
  3. To fund the put buy, a call option was created on the stock.

A protective collar may also be thought of as a mix of a covered call and a long put position.

Both the put and call options are typically out-of-the-money (OTM) and must have the same expiration date. The combination of long put and short call options creates a “collar” for the underlying stock defined by the strike prices of the put and call options. The “protective” component of this approach stems from the fact that the put position protects the stock against further decline until the option expires.

Protective Collar Options Strategy. Image by Julie Bang © Investopedia 2019

Because the collar’s primary goal is to hedge downside risk, the strike price of the call written should be greater than the strike price of the put bought. If a company is trading at $50, a call with a strike price of $52.50 may be issued, and a put with a strike price of $47.50 can be acquired. The $52.50 call strike price limits the stock’s gains since it may be called away if it trades over the strike price. Similarly, the $47.50 put strike price acts as a floor for the stock, providing downside protection below that level.

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When to Use a Protective Collar

A protective collar is often used when an investor needs downside protection in the short to medium term but at a lesser cost. Because purchasing protective puts may be costly, writing OTM calls can significantly reduce the cost of the puts. In reality, most stocks may have protective collars that are either “costless” (sometimes known as “zero-cost collars”) or create a net credit for the investor.

The biggest disadvantage of this approach is that the investor foregoes upward potential in the stock in exchange for downside protection. The protective collar works well if the stock falls, but not so effectively if it rises and is “called away,” since any extra gain beyond the call strike price is forfeited.

Thus, in the previous example, if a covered call is placed at $52.50 on a $50 stock, if the value climbs to $55, the investor who wrote the call would have to surrender the shares at $52.50, foregoing a further $2.50 in profit. If the stock rises to $65 before the option expires, the call writer will lose an extra $12.50 in profit (i.e., $65 minus $52.50), and so on.

Protective collars are especially effective when the general markets or individual equities show symptoms of reversing following a significant surge. In a strong bull market, they should be utilized with prudence since the chances of stocks being called away (and therefore restricting the upside of a given company or portfolio) are fairly high.

Constructing a Protective Collar

Let’s look at how a protective collar might be built using a historical example from Apple, Inc. (AAPL), whose shares ended at $177.09 on January 12, 2018. Assume you own 100 shares of Apple that you bought at $90, and with the stock up 97% from your purchase price, you want to use a collar to safeguard your profits without selling your shares entirely.

To begin, write a covered call on your Apple investment. Assume the March 2018$185 calls are selling at $3.65 / $3.75, and you write one contract (with 100 AAPL shares as the underlying asset) to produce $365 in premium income (less commissions).You also purchase one contract of March 2018$170puts at $4.35 / $4.50, for a total cost of $450. (plus commissions).The collar consequently has a net cost of $85, minus commissions.

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Scenario Analysis

The technique would function as follows in each of the three scenarios:

Scenario 1– Apple is trading above $185 (say $187) just before the March 20 option expiration date.

In this example, the $185 call would be worth at least $2, while the $170 put would be worth close to nothing. While you could simply close out your short call position (remember, you made $3.65 in premium income for it), let’s pretend you don’t and are OK with your Apple shares being called away at $185.

Your overall gain would be:

[($185 – $90) – $0.85 net cost of the collar] x 100 = $9,415

Remember what we stated before about a collar limiting the stock’s upside? If you had not used the collar, your profit on the Apple position would have been as follows:

($187- $90) x 100 = $9,700

You had to forego $285 or $2.85 per share in extra profits by adopting the collar (i.e., the $2 difference between $187 and $185, plus the $0.85 collar fee).

Scenario 2– Apple is trading below $170(say $165) very shortly before the March 20 option expiration.

The $185 calls would be for next to nothing in this situation, but the $170 puts would be worth at least $5. You then exercise your right to sell your Apple shares for $165, resulting in an overall gain of:

[($170- $90) – $0.85 net cost of the collar] x 100 = $7,915

Without the collar, the gain on your Apple shares would be just $7,500 (the difference between the current price of $165 and the starting purchase of $90 times 100 shares). By offering downside protection for your AAPL stake, the collar helped you earn an extra $415.

Scenario 3– Apple is trading between $170and $185 (say $177) very shortly before theMarch 20 option expiration.

In this example, the $185call and $170put are both trading at zero, and your sole expense is the $85 invested in establishing the collar.

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The theoretical (unrealized) gain on your Apple investment would be

$8,700 ($177- $90) less the $85 cost of the collar, or $8,615

Tax Advantages of a Collar

A collar may be an efficient approach to safeguard the value of your investment while potentially costing you nothing. However, it has several important aspects that may save you (or your successors) money in taxes.

What if, for example, you possess a stock that has increased dramatically since you purchased it? Perhaps you believe it has more upside potential, but you are worried about the market as a whole driving it down.

One option is to sell the stock and then repurchase it after the market has stabilized. You may even be able to acquire it for less than its current market worth and save some money. The issue is that if you sell, you will be required to pay capital gains tax on your earnings.

You may hedge against a market decline using the collar approach without triggering a taxable event. Of course, if you are obliged to sell your shares to the call holder or choose to sell to the put holder, you will have to pay taxes on the profit.

You may be able to assist your beneficiaries as well. As long as you do not sell your stock, they will be able to benefit from the step-up in basis when they inherit it from you.

The Bottom Line

A protective collar might be a more cost-effective approach of getting downside protection than just purchasing a protective put. This is accomplished by writing an OTM call on a stock holding and utilizing the premium to purchase an OTM put. The cost of mitigating downward risk is reduced overall, but upward potential is limited.

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