Collar Option Strategy and Why You Should Use It
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Collar option strategy is a protective option strategy that is used to protect traders investment after a long position in a stock has made substantial gains. Collar option strategy is another good option trading strategy that investors who have already made a profit from his stock can use to lock his profit and also make extra profit.
Collar option strategy just like other stock trading strategies depends on the investors perception of the direction and strength of the stock. Collar strategy allows investors to have upside capital gain while at same time providing maximum downside protection to the traders investment. Collar option strategy is also known as hedge wrapper.
How Collar Option Strategy Works
The collar strategy allows investors to buy an out-of-the-money put option and in the same way sell an out-of-the-money call option in the same security.
Lets give an instance of how collar option strategy works:
An investor believed strongly that stock of “TTY” is going up. Instead of purchasing a put and selling a call that have the same strike prices, the investor sell a call option that is even further out-of-the-money. By selling a call that is further out-of-the-money the investor have more opportunity to get larger increase in the price of the stock because the date the stock would have been called has been extended. The investor also retains the ownership of the stock during the period the price of the stock is increasing.
However, the investor will have to pay more to maintain the position because by increasing the distance of the options strike price away from the stock, the investor have succeeded in decreasing the amount of the calls premium. Nonetheless, the investor will have to pay out more money for the put than he will receive from the call.
Here is another example
If our investor from the above example purchased the stock of TTY at $5 and he wants to create a protective collar by purchasing the put with the strike price of$3, in the same, he intends to sell a call with a strike price of $7.
Now, here are three possible outcomes from the above action when the option expire:
First, lets assume that the stock price ends above the $7, another investor who purchased the call from our original investor will exercise the call. This implies that the investor sells his stocks at $7 strike price. This also would make him $2 in profits because he purchased the stock at $5 and sells at $7 making profit of $2. The profit he made is from selling the call and buying the put.
Another outcome is that the price of the stock falls below $3; the investor now sells it for $3 so that the trade can only make $2 loss. Remember that our investor has made profit from selling the call and purchasing the put.
The third outcome is when the price of the stock is between $3 and $7. This will leave the investor with the stock and the profit he made from selling the call. However he will have to subtract the price he paid for the put option and the fees he paid.
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Some Key Points in Collar Strategy
The collar option strategy is a very good strategy for an investor who has strong feeling that the price of the stock will go up.
This strategy allows for a limited but sustained appreciation of capital for a long stock position while at same time providing a limited fixed downside exposure.
Collar option strategy can help you to protect yourself from massive losses. However, you should bear in mind that this strategy can also prevent massive gains.
This strategy is also excellent strategy to use if the investor is writing covered calls to make premiums but also intends to protect himself from an unforeseen sudden drop in the price of the underlying security.
To know the profits or risks involved with Collar strategy, we will take a look at the formula for calculating it.
Limited Profit Potential Using Collar Option Strategy
This formula for calculating maximum profit
Maximum Profit = Short call Strike Price Purchase Price of Underlying + Net Premium Received Commissions the investor paid.
Maximum Profit made when price of underlying is greater than strike price of short call.
Limited Risk Involved with Collar Option Strategy
Maximum Loss = Purchase Price of Underlying Strike Price of Long Put Net Premium + Commissions the investor paid.
Maximum Loss is recorded when the price of underlying is less than strike price of long put.
Break Even Point
The investor breaks even when:
Breakeven Point = Purchase Price of Underlying + Net Premium Paid
One major benefit of using collar option strategy is that you will have the idea of what your potential losses and gains will look like. It is also gives you the benefit of offering security to your investment gains.