Collar strategy is the protective strategy that provides maximum downside protection and some upside capital gain. The collar is an aggregation of covered call and protective put strategies. It uses a long put position coordinated with short call position in addition to long stock position. The ratio of the aggregation is one long put, one short call and 100 shares of stock.
It is to be remembered that 100 shares makes up one contract. Out of money puts and calls are the option used to construct the collar strategy. The main objective is the construction of protective put strategy without any payment for the put purchase. The main things discussed were premium in covered call strategy, collecting premiums over a period of time without paying them. We collect the premium by selling the call which is used for capital outlay offset that was incurred for the put purchase.
It is general belief that there is only one positive outcome out of three in protective put scenario and two out of three in covered call strategy. Protective put strategy was the one providing the downside protection. Therefore, it was a challenge to construct a protective put strategy without paying out money. And the solution that came in front was the collar strategy.The collar strategy has the characteristic over both the covered call strategies and protective put strategies. Like the protective put, the collar strategy has unlimited downside protection and upside caps on profit like covered call.
This strategy is called an even trade, which means that you neither pay nor you receive any money. In reality, you have to pay out a small or very small premium, depending on the options used. But the collar has the neutral goal in terms of premium.
In order to construct a collar strategy, sell one out of the money call and buy one out of the money put in every 100 shares of stocks owned. There is no doubt that there must be different strikes of call and put options. It is not possible that there may be an identical strike price in both call and put option to both in-the-money and out-the-money.
For example, a collar strategy may be constructed by the purchase of 27.5 puts and the sale of 30 calls with a stock price at $28.50. There is not much gap in the price of put and call option so that the funds generated by the cost of put purchase is equal to the sale of call.
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