The problem for anyone in the market is the threat of loss. Owning stock means you risk a decline in the price, and this is where some specific options-based protective strategies are exceptionally valuable. One such strategy is the collar.
The collar has three parts: 100 shares of long stock, a short call, and a long put. If the stock price rises, the call is exercised and the stock is called away. As long as the strike is higher than your basis in the stock, your profit comes from the option premium plus capital gains on the stock and any dividends earned while stock was held. However, exercise can also be avoided by closing the call or rolling it forward, or by entering a buy to close order on the short position.
If the stock price declines, the short call will expire worthless or can be closed at a profit. The long put will grow in value point for point with decline in the stock once the put is in the money. This strategy limits profit while putting a ceiling on losses. So while it is not going to create large profits, it does protect you.
The collar often is entered in stages, not all at once. For example, your stock rises and you sell a covered call. However, the stock then begins to decline. Rather than close the call and sell the stock, you open a long put to protect against the decline, should it continue.
The strikes of the typical collar are both out of the money. An example based on 100 shares and single option contracts:
Priceline (PCLN) closed on December 1 at $1,735.30 per share. Why enter a collar at this point? The trend appears troubling for anyone with a long position in this stock. The price has declined from $2,050 in early August, only three months prior, more than 300 points. Also, the post-decline consolidation did not hold beyond early November, when the previous support price of $1,775 was broken, and flipped to resistance.
Fearing further decline, a holder of a long position might want to open a collar to limit the risk of further decline. As an initial observation, the strike selected for the call should be higher than the basis in stock. Otherwise, exercise would result in a net capital loss.
As of this closing date, the following options could be opened with expiration in 18 days:
SELL 1737.50 call at bid of 27.70 (less $5 trading fee) = $2,765
BUY 1732.50 put at ask of 30.00 (plus $5 trading fee) = $3,005
NET debit = $240
Breakeven on downside, put strike minus debit (1732.50 – 2.40) = $1,730.10
This trade accomplished the two goals: Selling a covered call for income, and using that income to hedge downside risk. The collar costs $240, which is minimal considering its advantages. Below the adjusted basis in the put of $1,730.10, market risk is eliminated.
If the stock price as of expiration is lower than the short call’s strike of 1737.50, it will not be exercised. If the price is also above the put’s strike of 1732.50, the put expires worthless. So this defensive trade provides low-cost protection for $240. It becomes valuable if and when the price falls below the put’s net basis of $1,730.10. In that case, every dollar of loss in the stock is offset by a dollar gained in the value of the put.