What Are Options Collars?

A collar is composed of long stock, a short out-of-the-money (OTM) call option, and a long OTM put option, with the call and put in the same expiration. The collar's long put acts as a hedge for the long stock (potentially limiting its downside losses), and the short call helps finance the long put. Remember, investors may lose 100% of funds invested with long options. Like a covered call, the collar's short call also caps the potential profit of the long stock (see risk profile chart below).

The collar's max loss occurs if the stock price is below the strike price of the long put at expiration. At that point, the investor might choose to exit the stock position by exercising the put and letting the call expire worthless. If it's before expiration and the investor wants to exit the stock by exercising the put, they'd likely want to close the call first because of the potential risks of holding a short call without the stock.

The max profit occurs if the stock price is above the strike price of the short call at expiration because the shares will be sold at the strike price when the short call is likely assigned and the put expires worthless. The risk profile above shows the limited risks and returns of the collar strategy. Keep in mind, this is theoretically what should happen. However, carrying options positions into expiration can entail additional risks; for example, an unanticipated exercise/assignment event could occur, or an anticipated event may fail to occur.

Traditionally, an options trader might place a collar over their long stock, and let it expire without adjusting it. But the nature of collars gives them flexibility, not only when putting the collar on, but also as time passes, and the stock price moves. In fact, larger investment managers use this flexibility to build a bigger stock position by using a strategy known as the "dynamic collar."

Technically, the collar is a bullish strategy with positive delta—meaning the strategy benefits from the long stock moving higher. But where does the delta come from?

Delta measures the expected change in value of an option for each $1 move in the price of the underlying security. Long stock has 100 positive delta for each 100 shares. Both the long put and short call have negative delta, but how much depends on their strike prices. The further OTM the long put or short call, the fewer negative delta they have, and so the more positive delta the collar has. If the long put and short call are closer to the current stock price, they have larger negative delta and offset more of the long stock's positive delta.

Let's say a trader is long 100 shares of stock at $50 per share. The 52-strike call has a -0.40 delta, the 48-strike put has a -0.40 delta, and the collar has +20 delta. Why?

100 stock shares @ $50 = +100 delta

The short 52 call = -40 delta

The long 48 put = -40 delta

100 + -40 + -40 = +20 delta

Now, suppose the 55-strike call has a -0.20 delta, and the 45-strike put has a -0.25 delta. A collar with those calls and puts would have +55 delta (-20 + -25 + 100 = +55).

100 stock shares @ $50 = +100 delta

The short 55 call = -20 delta

The long 45 put = -25 delta

100 + -20 + -25 = +55 delta

That's why the choice of strikes for the call and put determines how bullish the collar is. But it also means the delta of the collared stock position can change if the stock price moves down toward the long put strike or up toward the short call strike. In the collar example, with the 48 put and 52 call, if the stock moves from $50 down to $48, let's assume the delta of the call changes from -40 to -15 and the put from -.40 to -.50. The delta of the collar is then +35 from +20.

100 stock shares @ $48 = +100 delta

The short 52 call = -15 delta

The long 48 put = -50 delta

100 + -15 + -50 = +35 delta

Now, let's say the stock moves from $50 to $54, the 48 put now has a -0.10 delta, and the 52 call has an -0.80 delta. That would take the delta of the collar from +35 to +10.

100 stock shares @ $54 = +100 delta

The short 52 call = -80 delta

The long 48 put = -10 delta

100 + -80 + -10 = +10 delta

These numbers are hypothetical, but they illustrate how the combined delta of the collar can change as the underlying stock moves higher and lower. It's that changing delta that can make the collar "dynamic."

The dynamic collar originated with institutional investors and money managers who were looking to establish large positions in a stock over time but wanted a hedge against market corrections.

Let's start a new hypothetical collar with, say, buying 1,000 shares of a stock, buying 10 OTM puts as a hedge, and then selling 10 OTM calls to offset the cost of the puts. If the price of the stock drops, the long puts and short calls should theoretically be profitable because they have negative delta.

Assume a trader sells the long puts, buys back the short calls, and takes the profit to buy more shares. Suppose the profit is enough to buy 100 more shares. The additional 100 shares would make the stock position 1,100 shares, so the trader now buys 11 new OTM puts and sells 11 new OTM calls. The larger position could create more positive delta. So, the trader is getting larger delta (i.e., buying more stock) after the price drops, but still retaining the hedge.

Now, when the stock price drops, it doesn't mean the entire dynamic collar position is profitable. But that's not the point. Remember, the collar is, after all, a bullish strategy. And the idea is to build a position in the stock based on the dynamic fluctuation in the stock price. The loss on the long stock is usually greater than the profit on the long OTM put and short OTM call. To build a position, the idea is to establish a larger delta position in the stock at the lower price via a dynamic collar.

If the stock rallies, the collar could have an overall profit if the long stock has a higher profit than the losses on the long put and short call. In that case, the trader could potentially take the profit and move on to the next trade. Or they may be able to "roll" the long put into a higher strike closer to the new stock price and roll the short call to a higher strike further from the new stock price. Rolling the position often allows the trader to begin a new collar at the higher stock price.

Transaction fees could cut into some of the long stock's profit. But rolling to different strike prices, if the trader is still bullish on the stock, can sometimes help maintain roughly the same delta as when the collar was established.

Money managers with the capital to withstand large losses on long-term investments sometimes use collars in a dynamic way. In exchange for the risk of expanding losses, the dynamic collar can be more profitable if the stock price rallies back. Because the strategy often creates more positive delta as the stock rallies, the strategy could possibly break even, or be profitable, with a smaller rally in the stock price. Be sure to keep careful records as you track all the adjustments to a dynamic collar. Also, make sure you know the new breakeven stock price for the strategy after all adjustments are in place.

You might notice that the collar is synthetically similar to a long call vertical spread. In other words, a long stock plus a (protective) put has a similar risk profile as a long call with the same strike as the long put. Look at the risk profile below.

Because the long put is OTM, that synthetic long call is in the money (ITM). Combine the synthetic long ITM call with the short OTM call, and you have a long call vertical. The collar with the long 48 put and short 52 call is synthetically similar to the long 48/52 call vertical. In fact, the collar and the long vertical could, but not always, have the same theoretical max profit and max loss numbers.

So why don't investment managers just buy call verticals if they're synthetically similar to collars? Simple: voting rights and dividends. Owning stock shares gives you a voice in a company's business, such as board elections, mergers and acquisitions, and stock splits. Options, on the other hand, don't confer voting rights. Because the collar strategy is built around owning shares, the manager preserves voting rights. The owner of shares of stock also collects any dividends paid, while the holder of a call spread does not.

The dynamic collar strategy can also rack up transaction fees because of increased trade frequency and increased position size. If you employ the strategy, make sure the potential profits are large enough to cover any transaction fees.

What if the investor doesn't buy 1,000 shares of stock? Are 100 shares more appropriate for the investor's account. Do dynamic collars still make sense? That question would need to be evaluated by each investor.

In a scenario where the stock price drops and an investor uses the profit from a long put and short call to buy more shares, the profit might not be enough to buy 100 shares. Although it's possible to trade odd lots (less than 100 shares) of stock, there could be a mismatch between the options position's contract size and the number of shares.

For example, if the profits from a collar composed of 100 stock shares, long one put, and short one call are enough to buy 10 shares of stock, the position will have 110 shares. But each standard equity stock option has a deliverable of 100 shares per contract. There aren't standard equity options with a deliverable of 110 shares. One long put and one short call hedge only 100 shares. But two long puts and two short calls might be too much of a hedge.

A long call vertical spread is a less capital-intensive strategy that has risks and rewards similar to the collar (see the risk graph above). However, in the absence of long stock, a way to make the call vertical dynamic is with delta. How many positive delta does the long call vertical have, and how many delta does the trader want when the stock price drops?

Using our 48/52 collar example with the stock at $50, the synthetically similar call vertical would simply be long one 48 call and short one 52 call with a delta of +20. No stock and no put here.

Now, suppose the stock price immediately drops to $48, and the 48/52 call vertical loses $40. The collar could also lose the same $40, but that would be made up of, hypothetically, a $200 loss on the stock and a $160 profit on the long 48 put and short 52 call. After closing the collar, the investor could use the $160 to buy three shares of stock at $48 (not including transaction fees). But instead of buying three shares, the long call spread's delta may increase by a little more than 3%, which is similar to adding three shares to a 100-share position.

Like the dynamic collar, trading long verticals in this way can result in additional transaction fees.

And that's how some investors build a bigger position without spending extra capital. Although dynamic collars may be more geared for active traders and require a fundamental grasp of delta that may seem complex at first, it's worth taking a close look at the strategy, as well as the less capital-intensive vertical call spread, that the pros have been running with for years.