Protective Collars

Learn how to use the Protective Collar risk management strategy to hedge your existing portfolio against a sudden decrease in the stock

Put Strategy | Hedging Strategy

Protective Collars

Learn how to set up and profit from Protective Puts

The investor adds a collar to an existing long stock position as a temporary, slightly less-than-complete hedge against the effects of a possible near-term decline.

Description

An investor writes a call option and buys a put option with the same expiration as a means to hedge a long position in the underlying stock. This strategy combines two other hedging strategies: protective puts and covered call writing.

Usually, the investor will select a call strike above and a long put strike below the starting stock price. There is latitude, but the strike choices will affect the cost of the hedge as well as the protection it provides. These strikes are referred to as the ‘floor’ and the ‘ceiling’ of the position, and the stock is ‘collared’ between the two strikes.

The put strike establishes a minimum exit price, should the investor need to liquidate in a downturn.

The call strike sets an upper limit on stock gains. The investor should be prepared to relinquish the shares if the stock rallies above the call strike.

In return for accepting a cap on the stock’s upside potential, the investor receives a minimum price where the stock can be sold during the life of the collar.

Outlook

For the term of the option strategy, the investor is looking for a slight rise in the stock price, but is worried about a decline.

Collar (Protective Collar)

Net Position (at expiration)

EXAMPLE

Long 100 shares XYZ stock

Short 1 XYZ 65 call

Long 1 XYZ 55 put

MAXIMUM GAIN

Call strike – stock purchase price – net premium paid OR Call strike – stock purchase price + net credit received

MAXIMUM LOSS

Stock purchase price – put strike – net premium paid OR Stock purchase – put strike + net credit received

Summary

The investor adds a collar to an existing long stock position as a temporary, slightly less-than-complete hedge against the effects of a possible near-term decline. The long put strike provides a minimum selling price for the stock, and the short call strike sets a maximum profit price. To protect or collar a short stock position, an investor could combine a long call with a short put.

Motivation

This strategy is for holders or buyers of a stock who are concerned about a correction and wish to hedge the long stock position.

Variations

N/A

Max Loss

The maximum loss is limited for the term of the collar hedge. The worst that can happen is for the stock price to fall below the put strike, which prompts the investor to exercise the put and sell the stock at the ‘floor’ price: the put strike. If the stock had originally been bought at a much lower price (which is often the case for a long-term holding), this exit price might actually result in a profit. The short call would expire worthless.

The actual loss (profit) would be the difference between the floor price and the stock purchase price, plus (minus) the debit (credit) from establishing the collar hedge.

Max Gain

The maximum gain is limited for the term of the strategy. The short-term maximum gains are reached just as the stock price rises to the call strike. The net profit remains the same no matter how much higher the stock might close; only the position outcome might differ.

If the stock is above the call strike at expiration, the investor will likely be assigned on the call and liquidate the stock at the ‘ceiling’: the call strike. The profit would be the ceiling price, less the stock purchase price, plus (minus) the credit (debit) from establishing the collar hedge.

If the stock were to close exactly at the call strike, it would expire worthless, and the stock would probably remain in the account. The profit/loss leading up to that point would be identical, but from that day forward the investor would still continue to face a stockowner’s risks and rewards.

Profit/Loss

This strategy establishes a fixed amount of price exposure for the term of the strategy. The long put provides an acceptable exit price at which the investor can liquidate if the stock suffers losses. The premium income from the short call helps pay for the put, but simultaneously sets a limit to the upside profit potential.

Both the potential profit and loss are very limited, depending on the difference between the strikes. Profit potential is not paramount here. This is, after all, a hedging strategy. The issues for the protective collar investor concern mainly how to balance the level of protection against the cost of protection for a worrisome period.

Breakeven

In principle, the strategy breaks even if, at expiration, the stock is above (below) its initial level by the amount of the debit (credit). If the stock is a long-term holding purchased at a much lower price, the concept of breakeven isn’t relevant.

Volatility

Volatility is usually not a major consideration in this strategy, all things being equal. Since the strategy involves being long one option and short another with the same expiration (and generally equidistant from the stock value), the effects of implied volatility shifts may offset each other to a large degree.

Time Decay

Usually not a major consideration. Since the strategy involves being long one option and short another with the same expiration (and generally equidistant from the stock value), the effects of time decay should roughly offset each other.

Assignment Risk

Yes. Early assignment of the short call option, while possible at any time, generally occurs only just before the stock goes ex-dividend.

And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

Expiration Risk

The option writer cannot know for sure whether or not assignment actually occurred on the short call until the following Monday. However, this is generally not an issue since the investor has stock to deliver if assigned on the call.

Comments

This strategy lends itself to use as a LEAPS® hedge, where time value tends to make premiums higher and the period of protection is longer. The collar offers more protection than a covered call, but at a lower up-front cost than a protective put. See both of these alternatives for additional details.

Related Position

Comparable Position: N/A

What is an options spread?

An options spread is an options strategy involving the purchase AND sale of an option at different strike prices OR different expiration dates.

All options spread are set up as the same type. They are either all call options or all put options and on the same underlying asset

They differ in only the expiration date or the strike price.

They are set up with the same number of buy options as sell options. If you buy 5 call options, you will also sell 5 call options.

What are the 3 main types of options spreads?

A bullish long call diagonal spread is set up by

vertical spreads
horizontal spreads
diagonal spreads

What are Vertical Spreads

Vertical spreads are options that differ only in terms of strike price. They will have the same expiration and are of the same type ( all calls or all puts )

Option Basics

Motivations

This is primarily a stock acquisition strategy for a price-sensitive investor. Unlike a naked put writer whose only goal is to collect premium income, a cash-secured put writer actually wants to acquire the underlying stock via assignment. The strike price, less the premium received, represents a desirable purchase price.

However, the put assignment is not guaranteed. Should the stock price remain above the strike during the life of the option, the investor will miss out on the stock purchase. The consolation would be pocketing the premium received for the put.
If the investor is intent on acquiring the stock and is less concerned about price, there are other strategy choices worth considering.

Blurb –

Option Basics

Variations

A cash-secured put is a variation on the naked put strategy. The main difference is that the cash-secured put writer has set aside the funds for buying the stock in the event it is assigned and views assignment as a positive outcome.

In contrast, the naked put writer hopes that the put will keep losing value so the position won’t be assigned and can be closed out early at a profit. This investor would have to liquidate other assets quickly, or borrow cash, to be able to honor an assignment notice.

Blurb –

Option Basics

How Does a Call Option Change with Volatility and Time

A call option will benefit from :

A rise in stock prices
A rise in volatility
An early rise in stock price ( time kills the stock value )

Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.

Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.

Negative Theta – The passage of time will have a positive impact on this strategy, all other things being equal. As expiration approaches, the option tends to move toward its intrinsic value, which for out-of-money puts is zero. If the original forecast and goals still apply, the investor keeps the premium and is free to either buy the stock outright or write a new put.
The extrinsic value of options decays as time passes, which is detrimental to a call buyer

Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega ———
Whereas an increase in implied volatility would be considered an unqualified negative for a naked put writer, the effect could be described as neutral to slightly negative for the cash-secured put writer, all other things being equal.
If it now appears likelier that the put will be assigned, greater volatility is a neutral or perhaps even encouraging development.
However, greater implied volatility is clearly a negative in the sense that it can raise the put’s market value and thereby the cost of closing out the position. Remember, implied volatility is a measure of anticipated movement in either direction, up or down. Say, the investor is now convinced the stock will rally instead, and decides to purchase the stock outright before it goes any higher. Unless the investor is prepared to buy even more stock if assigned, the short put must be closed out, and its cost is now higher.

Buying a Call

Management and Adjustments

Maximum Profit Potential:
The maximum gain from the put option itself is limited. However, the optimal outcome is not readily apparent in the expiration profit/loss payoff diagram, because it does not address developments after expiration.
The best scenario would be for the stock to dip slightly below the strike price at the put option’s expiration, trigger assignment and then rally immediately afterwards to record heights. The put assignment would have allowed our investor to buy the stock at the strike price just in time to participate in the following rally.
From a strictly short-term perspective, the maximum possible gain occurs if the stock stays above the strike, causing the put option to expire worthless. The investor would keep the T-Bill cash originally set aside in case of assignment and simply pocket the premium from the sale of the option. While that is a benign outcome, it obviously doesn’t reflect the fact that the investor would rather be participating in the stock’s upward movement.
Maximum Loss Potential: The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor would be obligated to buy stock at the strike price. The loss would be reduced by the premium received for selling the put option.
Notice, however, that the maximum loss is lower than would have occurred, had the investor simply purchased the stock outright rather than via selling a put option.
Expiration Breakeven Price:
Since the object of this strategy is to acquire stock, the investor would break even if it is possible to sell the stock at the same effective price they paid for it.
Breakeven = strike price – premium
Estimated Probability of Profit: Less Than 50%
Assignment Risk?
Slight. Since the goal of this strategy is to acquire stock, assignment is not a problem. However, early exercise would require the investor to convert the interest-bearing asset to cash in order to pay for the stock.
Also, if assignment happened during a particularly severe downturn and the put writer has second thoughts about owning the stock at the strike price, the delay between assignment and notification means that the stock could fall further before the investor can act to limit losses. This is one reason why all option writers have reason to monitor the underlying stock very closely.
And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.
Expiration Risk
None. Since the goal of this strategy is to acquire stock, the investor should welcome an assignment at the option’s expiration.
Profit/Loss:
In a short-term sense, the potential profit (from the put option itself) is very limited, while the potential losses are substantial. The premium earned is comparatively small compensation for accepting the large downside risk of a stock owner. If the stock falls to zero, the put writer is obligated to buy a worthless stock at the strike price.
Still, this short-term view gives an incomplete picture of the risks and rewards. It is perhaps more appropriate to compare this strategy to buying the stock outright, since the goal of stock ownership is the same.
The cash-secured put does somewhat better if assignment occurs. The put writer gets a better purchase price than the original stock price. The ‘discount’ consists of the original out-of-the-money amount, if any, plus the premium received. Both investors face the risk of the stock’s falling to zero, but the put writer’s premium income reduces the loss at every level. And if the stock rallies back, the put writer’s gains are better by the amount of the premium.
The outright stock buyer is better off than the put writer if the put is not assigned and the stock keeps rallying. Granted, the put writer keeps the T-Bill interest and the put premium. However, the stock has gotten even further away from the original target price and would now cost more to get into the portfolio.

Long Horizontal Spread - neutral strategy

Vertical Spreads

How Do You Set Up a Horizontal Spread?

Short Call Calendar Spreads ( credit spread )

buy a call in a front month
sell a call in a back or distant month

Long Call Calendar Spread ( debit spread )

sell a call in a front month
buy a call in a back month
profit from increasing implied volatility

Short Put Calendar Spreads ( credit spread )

buy a call in a front month
sell a call in a back or distant month

Long Put Calendar Spread ( debit spread )

sell a call in a front month
buy a call in a back month
profit from increasing implied volatility

Option Basics

Tips and Tricks

Investors are told repeatedly to be wary of short option strategies, and quite rightly so. Without question, they entail tremendous risk, far greater than the limited premium income. They are definitely not suitable for all investors and situations.
However, here is a short option strategy with a risk profile that is identical to the covered call. Though far from risk-free, covered call writing is considered a perfectly legitimate strategy for many equity investors.
The key here is the cash-secured put investor’s intent to acquire the underlying stock regardless of the near-term lows it might hit. So as long as the put writer is comfortable with assignment and the downside risks of the stock, this strategy isn’t inherently more dangerous than a covered call. Of course the risk is large if the stock is falls to zero. However, that risk applies to all stock owners and covered call writers, too.