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Managing Risk Using Options: Equity Collars and Cash-Secured Equity Puts

Managing Risk Using Options: Equity Collars and Cash-Secured Equity Puts

Key Points
  • Equity collars and cash-secured equity puts (CSEPs) are two options strategies that traders can use to help limit the risks of a long equity position.

  • Collars can be a low cost way to provide short-term protection against a downturn in a stock, but they also remove most of the upside potential.

  • CSEPs can be an effective way to attempt to buy a stock below its current price or profit without owning the stock. Downside risk is reduced but not eliminated.

The final article in this series discusses two option strategies traders often use to help limit the risks of a long equity strategy: equity collars and cash-secured equity puts (CSEPs). A collar can have minimal costs to implement and a CSEP can be an effective way to attempt to buy a stock below its current price, or profit without owning the stock.

Equity collar: long stock, long puts and short calls, in equal quantity

A collar is a risk management strategy that essentially combines a covered call and a protective put. An investor who establishes a collar is usually slightly bearish or neutral, but primarily concerned with protecting a long stock position at minimal expense. A collar provides short-term protection against a downturn in the stock, but also removes most of the upside potential.

Because it's generally unwise to hold a long stock position if you think the long-term prospects are poor, you should only consider employing this strategy if you feel your stock might remain stable or trend down in the short term, but the long-term prospects are still favorable.

Probably the biggest benefit to trading a collar is that it can provide downside protection at little or no out-of-pocket expense—you can use the proceeds received from the sale of the covered calls to finance some or all of the purchase costs of the protective puts. In some instances, you may even be able to receive a net credit on the two option trades.

Two typical uses

Equity collars can be used in a couple different situations. The most common is when you want to protect an unrealized gain in your stock but you're not yet ready to sell the position. In this case, you would attempt to structure it so that you could only lose a small amount of your unrealized gain, but wouldn't sustain an actual loss on your stock investment.

Collars are also sometimes established when a long equity position is created. Generally, when this occurs, there is a potential for limited downside loss. However, by giving up some upside potential, you can establish your downside loss protection with little or no out-of-pocket expense.

Structuring an equity collar

Collars are often structured so that both the puts and the calls are out of the money and with the same expiration date. The ideal situation is if the stock increases just slightly (but not beyond the strike price of the call) after the collar is established. This will result in both the put and call options expiring worthless, and a small gain on the stock.

To illustrate this strategy, let's assume that about a year ago, you purchased 1,000 shares of XYZ at $52, and since then the stock price has risen to $72. You may be either neutral or optimistic about the long-term prospects for this company's stock, but in the short term you're either slightly bearish or neutral. In addition, you already have some realized capital gains for the year and you don't want to increase your tax liability, so you don't want to sell your position at this time.

Because you already have a 20-point unrealized gain in this stock, you may be willing to risk roughly a two-point downward move, but you want protection against anything greater. You're hopeful that the stock price will remain stable or modestly increase in the near term, but you don't expect it to shoot up during that time.

Here are some of the steps you could take to help manage the risk:

  • Protective puts could provide the downside protection you seek, but if there is no downward move, the premium you paid would be lost.
  • Covered calls would provide limited downside protection (to the extent of the premium received) and could generate a little income, but you could still lose all of your unrealized gains if there is a substantial drop in the stock price.
  • You could enter a stop order below the current price, but if the stock gapped down you could have larger losses than you expected, and you would end up selling your stock, thereby increasing your tax liability.

Essentially, you just want to hold steady, spending as little money as possible, without selling your stock, and without getting clobbered.

The solution may be to establish a collar by selling 10 XYZ 75 calls @ 2, and purchasing 10 XYZ 70 puts @ 2.

Establishing this position should result in you not losing more than two points of your unrealized gains, but also not adding any more than three points to the upside. Your only out-of-pocket expense would be the commissions charged by your broker. While it is possible to get assigned at any time on the short call options, you could generally prevent your stock from being called away, if the call options go in the money, by offsetting the call position with a closing trade. This would generally result in a loss on the call options, but should be offset by the additional unrealized gains in the stock.

  • If we graph this strategy (below), you can see that at expiration your break-even point is $72 (the current stock price).
  • If the stock drops to $70 or below, you won't lose more than $2,000, but if the stock increases beyond $75, you also won't gain more than $3,000.

Since, like most option strategies, the collar doesn’t necessarily have to be held until expiration, the following examples illustrate the possible actions you could take:

  • If the stock drops below $70, to prevent the exercise of the put options and the subsequent sale of your stock, you could sell the puts at their market value. The proceeds from the puts should offset all but two points of the loss on the stock.
  • If the stock rises above $75, to prevent the assignment of the calls and subsequent sale of your stock, you could buy your short call options to close at the market price. You would probably lose money on the call options, and the loss would reduce all but three points of the unrealized gains on the stock.

Note that the break-even point in the graph below represents the moment you establish the collar, not when you originally purchased the stock, back at $52.

Collar chart

Note: Chart depicts strategy at expiration.

A nice feature of a collar is that you can define the time frame. You may decide to establish a new collar each month, using options that expire in approximately 30 days or less. As long as you could do the trades at even money or a slight credit, this strategy can be beneficial because it may allow the stock price to gradually scale upward, increasing your unrealized profit—although it also takes the most amount of effort.

In the previous example, one of the potential outcomes was that at expiration the stock would end up above the strike price on the calls. If you were able to buy (to close) the calls without being assigned, you could for example end up with close to a three-point net gain on the stock, if the stock were at $77, and you were able to buy back the calls just before expiration for around $2, and let the puts expire. The following Monday after expiration you could then establish a new collar for the next month at higher strike prices—for example, consider selling calls with a strike of $80, and buying puts with a strike of $75. This might allow for additional upside potential in the next month.

If, on the other hand, you initially opted for a longer-term collar (perhaps using options that expire in six months), you could establish the position, and maintaining the position over that time would take less effort. However, you would also lock in a maximum gain of no more than three points for six full months. The choice is up to you.

Cash-secured equity puts (CSEPs): any number of short uncovered put options

A CSEP is similar to an uncovered (naked) put strategy, except that with a CSEP, you would deposit the total amount of the potential assignment with your broker in the event the put expires in the money, and the stock shares are "put" to you.

An investor who establishes a CSEP is generally neutral or slightly bearish in the short term, but bullish on the underlying stock in the long term. Because a significant drop in the price of the underlying stock would likely result in you being forced to purchase the stock for more than the current market price, you generally don't want to establish a CSEP if you feel the stock might drop significantly below the strike price on the put.

Before selling a CSEP you should always ask yourself, "Would I be happy if I had to buy the underlying stock at the strike price on this option?" If you can answer yes to this question, then this is a strategy you may want to consider.

While this may not sound like an option strategy designed to limit risk, it does have limited downside protection. When you sell a CSEP, because you may offset the purchase price of the stock at the time you sold the puts, you effectively reduce the risk of a decline in the stock from the original price down to the strike price. This will happen until the stock drops sufficiently in price to cause the put to expire in the money and be assigned, at which point you may begin to lose money.

Typically, you might consider this strategy if you are interested in purchasing a stock that you're bullish about in the long term, but are concerned that it might go down a little in the short term. The secondary potential benefit of this strategy is that if the stock doesn't make a short-term downturn, you'll miss out on owning the stock, but you can still make a small profit on the put option, with no further obligation. Keep in mind that you still have significant risk if the stock declines below the strike price.

While a naked put is generally considered a speculative strategy, a CSEP typically is not, because it requires that you keep a deposit with your broker for the full amount of the potential loss. This ensures that you won't be forced to lose money that you don't have.

How a CSEP works

To illustrate a typical CSEP strategy, let's assume you like the long-term prospects for XYZ, and you're interested in buying 1,000 shares at the current price of $72. You think $72 is a fair price, but you're concerned that XYZ may take a small dip in the short term. You could spend $72,000 for 1,000 shares, but instead you decide to sell 10 XYZ 70 puts @ 2. To do so, you would need to have $68,000 of available cash with your broker (the difference between the potential assignment obligation of $70,000 and the $2,000 premium you receive on the sale of the puts). During the life of your CSEP strategy, these funds will be segregated and unavailable for other use. If the CSEPs eventually expire worthless, the funds will be released.

If you were correct about the short-term dip, and the stock drops below $70 at expiration, your short puts would be exercised against you, and you would be assigned 1,000 shares at $70. You've just bought a stock for $70 for which you were previously willing to pay $72.

If the stock stays above $70, the puts expire worthless and you keep the $2,000 you brought in on the option trade, with no further obligation.

If we put this CSEP strategy on a graph, it shows that the breakeven price is $68, but the profit is capped at $2,000 for all prices above $70. It also shows that although you would have two points of downside price protection, you would incur losses below $68, all the way down to a price of zero, and a maximum potential total loss of $68,000.

CSEP Chart 

Note: Chart depicts strategy at expiration.

What's more, unless the stock price exceeds $74 by the expiration date of the puts, you would be better off having written the CSEPs than purchasing the stock outright. If the stock rises sharply and exceeds $74, you would have missed an opportunity for a larger gain, but you would still make a profit. If the stock drops below $68, you would begin to lose money, but your losses would always be $4,000 less than if you had purchased the stock outright at $72.

This strategy can help manage risk: Under all circumstances, you would either make a profit or lose less money than if you had simply bought the stock.

A key feature of CSEPs is that because the maximum potential loss is easily determined, you can use this strategy in a cash account or an IRA, as long as there's sufficient cash to cover the full cost of the assignment, and your account is approved for the appropriate level of option trading.

Words of warning

Let's reiterate a few precautions about the two strategies discussed:

  • This strategy is primarily a protective measure, and will usually reduce your profit potential if a stock moves substantially in your favor.
  • Any time you purchase a long option, you have acquired the right, but not the obligation, to trade stock at the strike price. If you choose not to exercise an in-the-money option, you will generally have the ability to close out that option in the market at any time prior to expiration. Because long options lose time value as expiration approaches, your options may lose value over time, even if the price of the stock remains stable.
  • Keep in mind that if your call option is in the money, you could be assigned at any time. 


  • While this strategy provides limited downside risk, it cannot eliminate risk entirely.
  • If the price of the underlying stock drops substantially prior to the expiration date of the put option, your losses could be significant. Losses would be limited to the strike price down to zero less the premium received on the sale of the puts.
  • While a significant increase in the price of the underlying stock will generally result in a profitable trade, profits will be limited to the premium received on the sale of the puts.
  • Keep in mind that if your put option is in the money, you could be assigned at any time.

Always protect yourself, hedge your positions and remember: Any gain is better than any loss.

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