A collar consists of three parts: 100 shares of long stock, one OTM covered call, and one long OTM put. The cost of the put is covered by income from the call. If the stock price rises, it gets called away. If the stock price falls, you exercise or sell the put.
So why even open a collar?
There are three ways you can create consistent profits with collars:
- Use different strikes. If you use the same strike for both options, it is very difficult to create profits. In fact, by definition, this is not actually a collar, but a synthetic short stock position. But if both sides are slightly out of the money, you profit on one side or both sides of the option trade. For example, a stock was selling at $81.15 . At that time, you could set up a collar using 80 puts and 82.50 calls – both were slightly out of the money. The June 80 put was at 1.06 and the June 82.50 call was at 0.56. So for a net cost of $50 (plus trading fees) you set up the collar. If the stock price rises but remains under $82.50, the call expires worthless. If it falls lower than $80, the put gains intrinsic value. Both of these outcomes are possible before expiration, but it is tough to make a lot of profit unless the underlying price falls significantly.
- Use short-term calls and long-term puts. Another strategy involves buying longer-term puts and shorter-term calls, setting up the collar as a diagonal position. The theory here has two components. The out-of-the-money calls are likely to expire worthless and can be replaced several times before the put expires, creates overall profits. For example, a stock’s December 80 put was at 4.45. So buying that put and selling the June 82.50 call at 0.56 still leave about $400 to offset; but there are three more expirations before that happens, so the “installment collar” makes sense as long as premium levels justify it. Besides enabling you to set up a net zero-cost or small credit, you freeze downside risk with the put, hedging the underlying effectively.
- Incorporate the collar into a dividend timing strategy. Finally, the collar solves the problem for the risk-conscious trader who wants dividend income but does not want to risk losing money in the stock. A company’s dividend was at 3.01%. This is a decent return, but there is always the threat of losing money in the stock. The collar solves this. If you set up the collar before ex-date, you get the dividend, but the collar eliminates market risk for very little cost. In fact, exercise is desirable after ex-date because you still get the dividend. This frees up capital to repeat the strategy the following money in a stock with ex-dates – and then again in the months following. Moving in and out of stock to hold the position for a few days just to earn dividends gets you a much higher return than the annual yield, because you get dividends every month instead of quarterly. And the collar eliminates the market risk.