The Collar Strategy

If a concentrated stock position represents a large share of an investor’s wealth, then that investor is susceptible to idiosyncratic, or stock specific risk.  If this risk is neither diversified nor hedged, the investor’s portfolio could experience dramatic and volatile swings in value.  While most investors can diversify out of this risk by simply reallocating funds to other asset classes, an investor with a low cost basis does not have this option if he or she is not willing to pay the tax consequences.  This is why many investors turn to equity collars as a way to protect their concentrated stock positions in an economically efficient manner.

Equity collars, or simply collars, are option strategies employed to hedge, or protect, individual positions at a relatively low cost. Collars can be a useful strategy for investor portfolios with large concentrated stock positions.   The typical collar is established by holding shares of an underlying security, usually a stock, purchasing a protective put for stock downside protection, and simultaneously writing a covered call to help finance the purchase cost of the put. The underlying security could be a stock or ETF.  The collar is created by selling an out-of-the-money (OTM) call to generate income while simultaneously buying an out-of-the-money (OTM) put to provide the hedge. Combining these two options with their differing functionalities essentially “collars” the underlying stock position, using the premium received from the call sold to finance the cost of the protective put.  A collar, at its most basic level limits upside participation in the stock in exchange for the downside protection. 

The primary purpose of a collar is the protection of profits accrued in the underlying rather than the increase of returns on the upside. While this strategy still allows potential profit up to the short call strike, the primary goal is to provide a floor to protect against losses on the downside.  The profit or loss on a collar depends primarily on the direction and the magnitude of the stock move. The stock will profit up to the strike of the short OTM call and lose value as it drops to the strike of the long OTM put. At that point, any drop below the strike price of the put will be offset one-for-one by gains in the long put (at expiration). The best outcome for the collar would be for the stock to rally toward the short call strike price and settle slightly below it at expiration.   At that level, the call is not assigned and the stock has additional gains. 

Creating the collar

Selection of expiration dates and strike prices

Structuring the collar usually begins with determining the investor’s “pain point”.  Sometimes this is determined by a percentage move while other times it could be determined by a nominal dollar amount.  Either way, this pain point can help to decide how far out-of-the-money (OTM) and how far out-in-time the investor will choose to go.

Strike prices

  • In regards to the put strike price, at what level does the investor want the downside protection to begin?  What is the pain point? (5%, 10%, maybe 20% down)  
  • If the investors buys a put further OTM, it will be cheaper in relative terms, but the stock position will essentially lose more before the long put protection kicks in.
  • The puts that are closer to the current stock price, or at-the-money (ATM), provide more protection at a strike price closer to the stock’s current level, but are more expensive than the further OTM ones. 
  • If the investor prefers that the collar has a net near-zero cost (excluding commissions), buying a more expensive put is going to require the sale of an equally expensive call (a strike price closer to the current price); this provides less room for the stock to run up before the upside is capped.  Put skew usually yields strikes that are not equidistant from the current price of the stock.

Expiration cycle

  • On the put side, protection for a longer period might sound desirable, but protection comes at a cost.  One might have to sell the call strike for a longer period of time as well, covering those shares longer.
  • If a longer period of protection is desired, consider buying a longer dated put and selling a shorter dated call to take advantage of accelerated time decay. Rolling the short call over time could generate more credit and potentially provide more flexibility should the stock become more volatile, or a corporate event is approaching, such as earnings or an ex-dividend date.  This is especially important if your call goes in-the-money and you want to lower your potential assignment risk. 

Example:

An investor bought 1,000 shares of XYZ at $52, and still believes in the company’s long-term prospects.  She doesn’t want to sell her position, but is concerned about short-term downward movement, as the overall market volatility has begun to increase.  The investor determines that she is willing to risk about a $5 point downward move, but wants to be protected against anything greater. What can she do?

If she buys ten protective puts at the $47 strike, this will cost her $1.00 per contract or $1,000 total to lock in her hedge at the $47 level.  She is less concerned about a substantial increase in the price of XYZ, so she sells ten covered calls at the $55 strike to generate $1.00 per contract and finance the $1,000 cost of the protective puts.  At this point, she has on a zero-cost collar (excluding commissions) that offers protection at $47 or lower and caps her upside at $55 or higher, up until expiration.    

 How does her collared XYZ position perform at multiple price levels?  As you can see, the max loss occurs at $47, the max profit occurs at $55, and the break-even occurs at the current price of $52.  Why is the max profit price $55 instead of the $57 listed below?  Since she sold her call at the $55 strike, she will not participate in any upside gains above that strike.  This is a potential drawback of the strategy and could cause her to not only forego the upside potential of the stock move, but have her shares called away.  The collar is best suited for a neutral to slightly bullish bias on the stock and best suited for investors who understand the assignment risks of calls around expiration and ex-dividend dates.  Thus, if you believe that there is significant upside to your stock, then perhaps it is best to consider another strategy.

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