Aug 28, 2010


One of the most conservative option plays is called a collar.  The name is derived from the fact that there is a limit (or collar) on both the maximum profit and the maximum loss available from the position.

Collars are not popular among active option traders.  Because of their conservative nature, they appeal to investors whose main interest is in preservation of capital.  And that's just the right strategy for some investment clubs.

Here is a collar and how it works:
  • Buy 100 shares of stock
  • Write (sell) one covered call option
    • By selling the call, the investor sets a maximum selling price for the stock
    • That price is the strike price
    • the investor collects cash when selling the call
  • Buy one put option
    • By owning a put, the investor establishes a minimum selling price for the stock
    • No matter how low the stock declines, it can be sold at the strike price of the put option
    • The investor pays cash for the put option
  • Cost
    • Investors tend to prefer to sell the call at a higher premium than they pay for the put
      • Why?  To earn a profit when the stock price is unchanged and both options expire worthless
      • To have better downside protection, it may be necessary to pay more for the put than you collect for the call
At expiration

If the stock is above the call strike price, it is sold at the strike, resulting in a (usually modest) profit
If the stock is below the put strike price, it is sold at the strike, resulting in a modest loss.

The collar does not provide a guarantee against loss, but it does provide a limited loss.  That maximum loss is known in advance and depends on the strike prices and premium of the options bought and sold.

More details on the collar trade can be found at my blog.

Mark D Wolfinger

Expiring Monthly: The Option Traders Journal