Collar Option
(Hedge Strategy)

The collar option, sometimes called the hedge wrapper, can be viewed as a much cheaper alternative to purchasing a protective put.

In effect, setting up a collar functions as very cheap, even free insurance on your underlying stock position. Another way of viewing the trade is that it allows you to lock your shares into a predetermined share price range.

How the Collar Works

The collar option essentially works like this:

For each 100 shares of stock you own, you would buy 1 out of the money (OTM) put and sell 1 OTM call (covered call). The premium you receive on the covered call will more or less pay for the premium you pay purchasing the long put.

The collar option is a great way to get the same protection as purchasing a protective put but without paying much (or sometimes without paying anything at all). And since you're paying little to nothing for the protective put, you're actually getting better protection.

Eliminating the price of the put is equivalent to eliminating the deductible on an insurance policy.

Is it really free?

Of course not - when it comes to options and option trading, it's all about trade offs.

With the collar option, you've creatively financed your insurance policy by agreeing to give up all gains the stock would generate if its share price exceeded the strike price on the short call (covered call).

Example of the Collar

EXAMPLE: Imagine that you're going through a messy divorce, and you're afraid that your estranged spouse will gain access to your extensive portfolio and begin liquidating your long term holdings . . .

Wait. Wrong example. If this is the case, you need a good lawyer more than you need a good option trading strategy.

The classic example for an option collar hedge strategy is this: you're in a position where you've got stock, and maybe a lot of it, that you would be happy to unload.

For whatever reason, you're unable or unwilling to sell it at the current time. Maybe there are tax considerations, maybe you've been granted the stock or it's part of an Employee Stock Purchase Plan and there's a minimum holding period.

The collar option effectively locks your selling price into a pre-determined range. You'll miss out profiting on any large moves upward, but you won't get killed if the stock plummets either.

So let's assume that The XYZ Zipper Company is trading @ $35/share. You bought, or acquired, 100 shares 11 months earlier when the stock was going for $17.50/share. You're thrilled about the 100% return, but with the company's quarterly earnings release scheduled in just two weeks, you're a bit nervous.

You really want to hold the stock for a full year so you can pay long term rather than short term capital gains taxes. What to do, what to do?

You're in luck. One month out, the 32.50 puts and the 37.50 calls are each trading for $1 per contract (no emails! This is a simplified example--and for the sake of simplicity, commissions are also waived).

You purchase the 32.50 put and sell the 37.50 call. You pay out $100 and collect $100--the premiums cancel each other out.

If the stock ends up on expiration day trading anywhere between $32.50/share to $37.50/share, both put and call options will expire worthless and you're free to sell at the final share price.

Other Scenarios

What happens if the stock moves higher, say by $10 to the $45/share level?

In this case, your net proceeds on the collar option would be $3750.

The Math:The value of your stock is $4500 from the share price but you would also have a $750 obligation on the short call. You could buy back short call for $750 and sell the shares for $4500, leaving you with net proceeds of $3750. Since the stock closed above the $32.50 strike price of the long put you purchased, the put expires worthless.

Another choice would be to do nothing. Since this is a covered call situation, the call would be exercised and your shares would be "called" away from you at the $37.50 strike price, giving you, again, net proceeds of $3750. And, as before, the long put would expire worthless.

What happens if the stock moves lower, say by $10 in the other direction, down to the $25/share level?

In this example, your net proceeds would be $3250.

The Math: The value of your stock is $2500 based on the share price. The short call (covered call) expires worthless, but the long put you purchased at the $32.50 strike price is now $7.50 in the money ($32.50 strike less the $25/share price).

You could either sell to close the put for $750 and the shares for $2500, or you could just exercise the put and have your shares "put" to the put seller for the $32.50 strike price. Either way, the value is $3250.

Result: In both of these scenarios, and as far as you're concerned, you've locked the stock into a predetermined trading range of $32.50-$37.50/share.

Collar Variations

Depending on the circumstances, you might be able to set up the option collar with a tighter range. If the stock is trading right on a strike price, you should be able to buy and sell your options right at the money(ATM). In such a situation, there's no question of a trading range--you've essentially locked in a final price.

Your specific application of the collar option will depend on which metaphor your objectives are relying on. Are you trying to lock in a certain price to sell the stock on a future date? Or are you looking for cheap insurance and hoping/expecting the stock to gradually climb?

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