Crafting a Collar Strategy

By TradeSmith Editorial Staff

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Options are incredibly powerful tools for traders and investors.

Yet most folks never move beyond using them as directional bets, when they offer so much more.

Today, I want to introduce you to a fascinating strategy: the options collar.

You might roll your eyes since this doesn’t generate those exciting 100% returns in a matter of weeks. What it does is limit downside risk with a comparable cap on gains.

But I promise you that I have a whole new take that is going to surprise even the most seasoned options aficionados.

Understanding the Collar

A stock collar construction has three components:

  1. Long stock (100 shares per collar)
  2. A long put option
  3. A short call option
The put option protects the long stock against downside movement in the share’s price and requires a cash outlay.

To pay for this, you sell a call option that pays you cash. However, that limits your upside potential. Let me show you an example.

Say I own 100 shares of stock ABC.

  • Currently, the stock trades at $50.
  • I buy one put option with a $45 strike price to protect my downside. This contract costs me $3. Since one contract controls 100 shares of stock, the total cost is $3 x 100 = $300.
    • This option gives me the right to sell my shares at $45 until expiration.
    • If the stock falls below $45, I can use the contract to sell the stock at the higher $45 price.
  • Then I sell one call option with a $55 strike price. This limits my upside potential and pays me $3.
    • This option gives someone the right to buy 100 shares from me at the $55 strike price until expiration.
    • If the stock goes above $55, I lose out on the potential gains since the person who owns the call contract would buy my shares at the lower $55 price.
Here’s the outcome:

  • Since I own 100 shares of stock, the long put option protects me at $45 and below.
    • Thus, my total downside is $50 – $45 = $5 x 100 shares = $500.
  • The short call option limits my upside potential to the $55 strike price.
    • Thus, my total upside potential is $55 – $50 = $5 x 100 shares = $500.
Here’s what the payout graph looks like.

Source: TradeSmith

Why and When to Consider a Collar

Stock collars are not a strategy you want to use haphazardly. While they limit your potential losses, they also cap your gains.

Most traders will use this strategy on a stock they want to keep after a significant run higher in share price. While the stock could go higher, the downside risk has grown.

More importantly, this comes into play with stocks that pay hefty dividends.

Even though you limit your upside potential and downside risk, you still get to collect the dividend payments, both regular and special.

In fact, if you took the example above and chose a $50 strike price for the put and $50 strike price for the call (known as “at the money”), you would have no upside potential or downside risk, and you would still be able to collect the dividends from your stock positions.

But as you’ve probably guessed, it’s not always that simple.

An option’s price takes dividends into account.

That’s why put options always cost a little more than call options when they expire after a dividend date.

However, that doesn’t mean you can’t find special situations where you can use an at-the-money collar on a stock and still come out ahead.

Let’s look at another example.

Dow Inc. (DOW) currently trades at $60.74 and pays a dividend of $2.80 per year, or an annual yield of 4.6%. Keep this in mind, as we’ll come back to it in a minute.

If I moved ahead one year in time to the January 2023 expiration cycle, I could:

  1. Buy a $60 put contract for $7.65
  2. Sell a $62.50 call contract for $5.45
This would cost me a net $2.20 per share. With the $60 put strike price, I would limit myself to $60.74 – $60 = $0.74 of downside risk per share.

But, with the $62.50 call strike, I offer myself a chance at $62.50 – $60.74 = $1.76 potential upside per share.

However, we can’t forget about the dividend payments.

I expect to get paid $2.80 over the course of the year, $0.70 per quarter to be exact, for owning the stock.

This effectively leaves me with $2.80 – $2.20 = $0.60 in cash left over from the dividends after I pay for the put option.

That cash lowers the risk of my trade to $0.74 – $0.60 = $0.14 per share. Plus, it means my maximum upside potential is now $1.76 + $0.60 = $2.36 per share.

So What’s The Catch?

Not all dividends are guaranteed. Many companies cut theirs during the downturn in 2020.

And your maximum potential here is $2.36 per share after all the dividends are paid out. That means you need to wait the ENTIRE year to achieve maximum profit, or at least until you get paid four quarterly dividends. It’s entirely possible that you wait the entire year and the stock finishes below $60, meaning you lose $0.14.

But this strategy creates a low risk, low reward trade that conservative investors might find appealing. And you can adjust the options to make things more lucrative.

For example, since the price of an option erodes at an exponential rate as it approaches expiration, you could go out one year with the put option and sell call options every three months. All things being equal, that would generate more total credits than just selling one call option that expires a year out.

This is just one of many possible ways to use options to craft unique investment tools.

What are some of your favorite options strategies? Email me and let me know. I can’t respond to every email, but I promise I read them all.