Protecting a Long Stock Position
When the stock position is long, the collar is created by combining covered calls and protective puts. From a profitability standpoint, the collar behaves just like a bull spread. The upside potential is limited beyond the strike price of the short call while the downside is protected by the long put.
Suppose you purchased 100 shares of Network Appliance (NTAP) at $12.84 in May and would like a way to protect your downside with little or no cost. You would create a collar by buying one JUL 10 Put at $0.60 and selling one JUL 15 Call at $0.80.
The long stock behaves the same as any long stock position--it gains when the stock goes up and it loses when the stock drops. However, the maximum profit is achieved when the stock is at $15. Above 15, the profit on the stock is exactly offset by the loss on the call option that was sold. On the downside, the maximum loss occurs with the stock at or below $10. Below $10, the profit from the put offsets the loss from the stock.
|NTAP trading @ $12.84|
|Buy 100 NTAP @ $12.85||$1,284.00|
|Buy 1 NTAP JUL 10 Put @ $0.80||$60.00|
|Sell 1 NTAP JUL 15 Call @ $0.80||($80.00)|
|Cost of Trade||$1,264.00|
The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. The key to implementing the collar strategy is selecting the appropriate put and call combination that allows for profit while still protecting the downside risk. Many investors will roll the puts and calls in the collar strategy each month and lock in a 3-5% monthly return. By rolling, you would buy back the short calls and sell new calls for a later month and perhaps different strike price, and do the same with the puts. Hence adjusting the collar based on the movement in the stock price. There may be tax benefits associated with long term capital gains on the stock in the collar strategy versus short term capital gains in a pure option strategy. Consult your tax advisor for more details.
In addition to retail investors, many senior executives at publicly traded companies use collars as a way to protect their personal wealth that might be heavily concentrated in their company's stock. By collaring their stock, an executive can insure the value of his/her stock without paying huge premiums for put insurance.