How the Protective Collar Strategy Works

Markets are in constant motion, and if you have a long position in an asset, you may be wondering how to manage your risk. A protective collar strategy is an options strategy that addresses market uncertainty.

An option involves the right but not the obligation to buy or sell an asset at a specified price (strike price) at a predetermined date (expiration date).

This article explores how a protective collar strategy works, how to set it up and the factors to consider before putting it in place.

Understanding a Protective Collar

A protective collar strategy combines a long asset position — for example, in a stock — with a long put position and a short call position on the same asset. 

We’ll discuss the strategy using stocks as the underlying asset in this article, although you can trade them on other assets if options are available.  

When to Use a Protective Collar

If you have bought a stock but would like to protect against downside, you might want to buy a put option to hedge against stock declines. However, buying put options requires paying an option premium, which can be expensive if your strike price is close to the current market price. 

To fund your put purchase, you can sell a call option and collect the option premium. In return, you give up profits from gains in the stock above the call strike price.

How to Set Up a Collar

When you decide to use a protective collar strategy, you can buy a new stock position or implement the strategy on an existing holding in your portfolio. 

First, choose a timeframe for the options strategy to determine the expiration date of the options. 

Then, choose the strike prices for your options, which will usually be out of the money. That means the put strike price will be lower than the current stock price, and the call strike price will be higher than the current stock price. The farther away the strike prices are from the current stock price, the less the options premiums will be.

Buy a put with the chosen strike price and sell a call with your preferred strike price. Both options should have the same expiration date.

Maximum Loss

Your maximum loss = stock entry price - put strike price - put option premium + call option premium

The maximum loss occurs at the put strike price.

Maximum Gain 

Your maximum gain = call strike price - stock entry price - put option premium + call option premium

The maximum gain occurs at the call strike price.

Breakeven

Your breakeven level occurs when the difference between the stock price and stock entry price offsets the net cost of the option premiums. 

In most cases, the put option is more expensive than the call option, so you would pay for the options on a net basis. When the stock price rises above your entry level, you profit from the long stock position. You break even when the profit on your stock position nets out the cost of the options.

Time Decay

Both options experience time decay, where options are worth less as time passes and the expiration date gets closer. Time decay benefits the short call option position and negatively affects the value of the long put option.

Implied Volatility 

Volatility represents the level of variation in the stock price. The implied volatility of the options impacts the value of the options. The higher the implied volatility of an option, the higher the option premium.

Possible Advantages of Using Protective Collar

A few of the benefits of a protective collar include the following:

• Hedging: The protective collar strategy gives you the ability to hedge more affordably because you are selling an upside call and giving away returns above the call strike price.
• Ability to hold: If you want to hold your stock for any reason, like, if you still want to receive dividends, then you can put on this hedging strategy even if you think the stock price will go down.

Things to Consider Before Using a Protective Collar

Consider these factors before putting on a protective collar.

• Assignment risk: Since you are short a call option, if the stock price is trading above the call strike price at maturity, your stock could be assigned away. That means that you would effectively give up your long stock position to cover the loss on the short call.
• Expiration: Your protective collar strategy expires at the expiration date because your options expire then. You would then be left with your long stock position that is unprotected.
• Cost: You will likely have to pay a net option premium to hedge your stock position, which can eat into potential profits.

Example of Protective Collar

Let’s say that a stock is trading at $100. Here are the three possible scenarios where you might apply the protective collar strategy.

You expect the stock to stay range bound, and you want to protect the downside: You might pay $2 for a $95 strike put option and sell a $105 strike call option for $1, paying net premium of $1. Both options expire at the same time.

You expect the stock to go down within 2 months, but you still want to hold the stock longer term: You might pay $5 for a $98 strike put option and sell a $102 strike call option for $3. Both options expire in two months.

Your stock position is falling in value, and you still want to hold the stock longer-term, but hedging with put options is expensive: You might pay $3 for a $95 strike put option and receive $3 for a 102 straight call option. Both options expire at the same time.

Learn About Protective Collar Strategies

The protective collar strategy allows you to fund a put option hedge on your long stock position by selling an upside call option. You give away upside performance in the stock above the call strike price, but you are protected if the stock price falls below the put strike price.

Frequently Asked Questions