Collar

Collar

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 26, 2021

Basics Concepts – Collar

Description – Collar

The Collar is similar to a Covered Call but typically works over a much longer time period and involves another leg—buying a put to insure against the stock falling.
The effect is of buying a stock, insuring against a downmove by buying puts, and then insuring the trade by selling calls.
Buy stock ➞ Buy asset
Buy puts ➞ Insure it from falling
Sell calls ➞ Finance the insurance
Buy the stock.
Buy ATM (or OTM) puts.
Sell OTM calls.
The closer the put strike is to the price you bought the stock for, the better insurance you’ll have if the stock falls. However, the better insurance you have in that regard, the more it will cost you!

Steps to Trading a Collar

Steps In

Try to ensure that the trend is upward and identify a clear area of Support.

Steps Out

Manage your position according to the rules defined in your Trading Plan.
At expiration, you hope that your call will be exercised and that you’ve made your maximum profit.
If the stock remains below the call strike but above your stop loss, let the call expire worthless and keep the entire premium.
The point of a Collar is that you set the put strike at or above your stop loss, creating a minimum risk trade. Therefore, you are at liberty to keep the position until expiration.

Context - Collar

Outlook

With Collars, your outlook is conservatively bullish.
This is supposed to be a very low-risk strategy.

Rationale

To execute a long-term trade that is inherently low-risk.
You will have to use online tools to determine how little risk you’re going to take.
Long-term trade that takes money out of your account, there is “opportunity cost”.

Net Position

This is a net debit trade because money will come out of your account to pay for the stock.
If you select the right strike prices for the bought put and sold call, you may even be able to execute this trade with no risk at expiration, even though money has been debited from your account in order to make the trade.
If the stock falls, then the ATM put (your insurance) will rise in value, and you will retain the premium received by having sold the OTM call.
This combination will offset the fall in value of the long stock.

Effect of Time Decay

Time decay will be helpful with the sold call; it will be unhelpful to the bought put and will have no effect on the stock you have bought.
The net effect is that time decay is helpful here when the position is profitable and harmful when the position is loss-making.

Time Period to Trade

You will be safer to choose a Longer time to expiration

Breakeven = [Stock price – call premium + put premium]

Exiting the Trade - Collar

Exiting the Position

If executed correctly, you will not need to exit this trade early because there should be very little risk.
Advanced traders may leg up and down as the underlying asset fluctuates up and down.
In this way the trader will be taking smaller incremental profits before the expiration of the trade.

Mitigating a Loss

This shouldn’t be an issue with the Collar!

Advantages and Disadvantages

Advantages

Give yourself maximum protection against a fall in the underlying stock price.
With volatile stocks, you can create a very low risk or even risk-free trade.
You can create a high yield on risk.

Disadvantages

Works best for long-term strategies (over one year), so it is slow.
Maximum upside only occurs at expiration.
Creates only a low reward on capital expended.

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