How to Use Options Collars on a Long ETF Position

June 20, 2023
With a little tweaking, the hedging strategy known as an options collar can help you generate extra income from a range-bound long ETF position.

When markets are volatile, high-volume exchange traded funds (ETFs) will sometimes appear to be trapped in a range with well-defined ceilings and floors—and bounce up and down between them for several weeks. In fact, we may be seeing these conditions now. This can be exasperating, but experienced options traders try to take advantage of this pattern by tweaking a risk-management technique called an options collar.

Normally, a collar is a two-part strategy that works like this: You buy a put with a strike price below your position, to protect it in case it drops. At the same time, you sell a covered call with the same expiration date at a strike price above your position to generate income—ideally enough to offset the cost of the put—though, at the risk of giving up some potential gains. (As a reminder: Until expiration, a call option gives the owner the right to buy the underlying security; a put option gives the owner the right to sell the underlying security.) The idea is that for potentially zero cost, you can leave these positions in place as a type of "insurance" should your position go too far south. In that sense, a traditional collar is a fairly passive strategy.

With a range-bound ETF—especially one for which you have a long-term bullish outlook and prefer to hold until the market settles down—you would take a more active approach to setting up collars, with several potential benefits: You may be able to capture profits during the dips and rebounds and offset all or part of your losses during the downtrends. To be clear, this strategy can generate taxable income, so it may be more advantageous in a tax-advantaged account like an IRA.

Now, onto the strategy.

Range bound

The chart below is for a hypothetical ETF with the symbol XYZ. Over the six weeks from March 31 until May 15, XYZ traded in approximately a 10-point range (405–415). Market volatility as measured by the VIX was in a roughly four-point range (16–20), which is relatively low from a historical perspective. These are the kind of conditions in which an actively managed collar strategy could work.


Source: StreetSmart Edge®

Using front-month options, you would set up a collar each time your ETF is near the top of its range and then close it out each time it moves back down toward the bottom. In implementing this strategy, your goal should be for the premium you collect from writing the covered call to be slightly larger than what you pay for the put. Ideally, the resulting credit would be sufficient to cover the commissions.1

If your ETF moved as anticipated, you would receive a small credit when you establish the position and then a larger one when you close it out. Since calls lose value and puts gain value when a position falls, during a downward move, both options will generally work in your favor, so it's not necessary to open the position exactly at the top or close it out exactly at the bottom.

Additionally, because both options are initially out-of-the-money,2 if the ETF stays relatively flat and the collar expires, establishing it at a small credit will allow you to earn a relatively small profit, potentially even after commissions.

Active collar in action

Let's look at some examples using actual mid-day pricing for the XYZ, not unrealistic intraday highs or lows:

On April 18, when the XYZ was around 413.80 (well below the intraday high of 415.72) the following five-point collar could have been established:

  • Sell to open 1  5/19/2023 417 Call @ 6.15
  • Buy to open 1  5/19/2023 412 Put @ 5.65
  • For a net credit of 0.50 (before commissions)1

This 0.50 equates to a credit of $50 per 1x1 collar; more than enough to cover the standard commission charges of ($0.65 per contract) or $1.30. The total net credit would therefore be $48.70.

Five days later, on April 25, when the XYZ was at approximately 408.38 (well above the intraday low of 406.02), the collar could have been closed out as follows:

  • Buy to close 1  5/19/2023 417 Call @ 3.14
  • Sell to close 1  5/19/2023 412 Put @ 7.86
  • For a net credit of 4.72 (before commissions)1

This 4.72 equates to a credit of $472 per 1x1 collar. Even after the standard commission charges of  $1.30 are deducted, that would give you a total net credit of $470.70, for an overall profit of $519.40, including the initial credit of $48.70 from when the collar was established. While the net loss on the XYZ position was $542, the collar offsets more than 75% of that loss.

Once the XYZ increases in price again, this (or a very similar) collar can be re-created. This is where you want to actively manage your position.

Three days later, on April 28, the XYZ was back up to 414.70 intraday (well below the intraday high of 415.94) and another five-point collar could have been established:

  • Sell to open 1  5/19/2023 417 Call @ 4.78
  • Buy to open 1  5/19/2023 412 Put @ 4.11
  • For a net credit of 0.67 (before commissions)1

Four days later, on May 4, by the time the XYZ had dropped to 406.19 (well above the intraday low of 403.74), the collar could have been closed out as follows:

  • Buy to close 1  5/19/2023 417 Call @ 1.38
  • Sell to close 1  5/19/2023 412 Put @ 8.25
  • For a net credit of 6.87 (before commissions)1

While the XYZ had dropped 8.51 points, the collar would have offset more that 85% of that loss. And because of your collars, you have earned more than 12 points, even though the XYZ is down less than nine points in aggregate.

Then, the very next trading day (May 5), the XYZ was again back up near the top of its range around 412.00, giving you the opportunity to establish another collar. At some point the pattern will inevitably end, but each profitable collar in the interim will lessen the eventual impact.

Because intraday swings can be extreme and unpredictable, you can lessen the burden of managing this strategy by using GTC (good 'til cancelled) limit orders and trying not to hit the exact top or bottom before each trade.

If you have several ETF positions, use the collar screen on any of our trading platforms to set up a few orders for small net credits. As the markets move around some of them are likely to be executed. Once that happens, use GTC orders again with larger credits to attempt to close them out. Markets tend to be most volatile at the open and near the close. It's likely that many orders may get filled during the first and last 30 minutes of the day.

The risks

While this strategy can be effective in a volatile or range-bound market, like many options strategies, it has some serious risks that need to be considered:

Early assignment: Your covered call could theoretically be assigned before you had the chance to close it out or roll out to the next expiration. Should this happen, you would lose your ETF position and could face tax consequences. Assignment usually only happens when the call option goes in the money,3 but that's not always the case. While early assignment can occur at any time, it is most likely to occur the day before the ex-dividend date or during the week of expiration.

Downside breakout: If you close out your collar at a profit when the ETF is at the bottom of its range, but it continues to go lower, you will have missed out on the potential for additional profits in the collar even as you incur additional losses in the ETF.

Upside breakout: If you establish the collar when the ETF is near the top of its range, but it continues to go higher, you will not only miss out on the opportunity to profit from the collar, but also cap your upside potential in the ETF. This could be partially mitigated by repeatedly rolling out to the next expiration. However, early assignment risk will always be there. Also, if the call goes deep enough in the money, the rollout may require a net debit to establish it (i.e., paying more in premiums than you collect in turn), which may not be desirable.

Tax complications: This strategy can generally be used in an IRA or other tax-deferred account without any problems. However, if you're using it in a taxable account, you should seek professional tax advice because a number of complications could arise:

  • All income earned on the collar options will typically be taxed at your ordinary income rate.
  • Be sure that both the call and the put options are out-of-the-money when you establish your collar or you could run afoul of the IRS "straddle" rules. These can be complicated, and you may not be able to deduct losses from your ETF until you close out your full position.
  • If you haven't held the ETF position for 12 months (qualifying for long-term capital gains treatment) establishing a collar could freeze or reset the holding period of your ETF position.
  • If the ETF goes ex-dividend when your collar is in place, the dividend probably won't qualify for the 15% long-term rate.
  • If the ETF position is closed out at a loss (whether through assignment or sale), IRS wash-sale rules will disallow the loss if you buy the ETF back again within 30 days.

For more information on the tax rules regarding options please consider reading the following publication:

IRS Publication 550: Investment Income and Expenses

Bottom line

The goal of this strategy is to earn short-term income that can partially or fully offset declines in the value of your ETF positions. It is clearly not a tax-efficient strategy, nor is it a strategy for inexperienced option traders. Because this strategy requires active management and close monitoring, I recommend you test it out with paper-trading first, and don't use it unless you can keep a close watch on your account and the markets.

1Typical Schwab online commission charges for a 1x1 collar transaction would be $0.65 per contract or $1.30. All broker-assisted and automated phone trades are subject to service charges. See the Charles Schwab Pricing Guide for details.

2Describes an option with no intrinsic value. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock. A put option is OTM if its strike price is below the price of the underlying stock.

3Describes an option with intrinsic value (not just time value). A call option is in the money (ITM) if the stock price is above the strike price. A put option is ITM if the stock price is below the strike price. For calls, it's any strike lower than the price of the underlying equity. For puts, it's any strike that's higher.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Multiple leg options strategies will involve multiple commissions. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 1-800-435-4000 for a current copy.

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

Past performance is no guarantee of future results.

For the sake of simplicity, the examples shown do not take into consideration commission and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of the strategies discussed. Please consult your tax advisor for more information on potential tax implications.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.