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June 22, 2022
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Collars
by Stephen Bigalow

The collar is a three-part strategy. It includes 100 shares of stock, one out-of-the-money long put and one out-of-the-money short call. This “hedge wrapper” accomplishes the elimination of market risk below the put’s strike, while limiting profits above the call’s strike. Since the two strikes are often quite close together (often the closest strikes out-of-the-money based on current price of the stock), what are the benefits of the collar?

First, it is most valuable when the basis of stock is much lower than the current price per share. In this situation, exercise of the short call generates the sale of stock at its strike, which will end up in a capital gain. If the stock price declines below the long put, you can exercise the put and sell stock at the put’s strike; or you can offset losses in the stock by selling the put at appreciated premium value. Second, as a defensive strategy, the collar (also called “protective collar”) serves as a portfolio management tool assuming two facts. These are that the basis in stock is much lower than the current price, and you will be willing to sell shares at the call’s strike to take profits. At the same time, you are also happy to continue holding shares, either for dividend yield or for expected future appreciation. In this case, if the short call moves in the money, it can be closed or rolled forward to avoid or defer exercise.

Third, the collar costs little or nothing and might even yield a net credit. This makes the collar superior to both the long put by itself, and the covered call. As a strategy to manage risk, the no-cost collar solves the problem of cost while entirely eliminating risk below the fixed strike of the put.

For example, on January 29, 2015, McDonald’s (MCD) had risen 3.96 one hour into the session and was worth $92.74 per share. If you had purchased 100 shares the day before, when the stock closed at $88.78, you would have a very desirable and fast paper profit. So what now? You can sell and take your nearly $400 profit. Or, if you believe the company’s stock might continue moving upward, you may consider opening the collar. This would fix the price at the put’s strike in the worst case. For example, buying a 92.50 put would ensure a profit of $372. If at the same time you set up a collar by selling a 93 call, you would cap potential profits at the $93 per share level, which represents a capital gain on the stock of $22. In both outcomes a profit results either from having your short call exercised, or you taking action to exercise your long put.

In the case of MCD, at the time the stock was at $92.74 per share, the following options were available:

February 93 call, bid 1.32, net after costs $123
February 92.50 put, ask 1.38, net after costs $147
Net cost of transaction $24

So, this strategy creates ensured profits whether the stock price rises or falls. It provides insurance against downside loss and programs in a capital gain upon exercise of either option (based on purchase price of $88.78 per share) of either $372 (if you exercise the put) or $422 (if your short call is exercised).

If the stock price rises above the call’s strike, you could also roll forward to avoid exercise or to defer it, or accept exercise and take profits. The collar provides benefits for very little cost. In this example, the net cost after adjusting between bid and ask and calculating estimated trading costs of $9 per share, is only $24. For such a small cost, this buys a lot of protection of paper profits.

 
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