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 the stock was held. However, exercise can also be avoided by closing the call or rolling it forward, or by entering a buy to close 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, hence collar.
The collar often is entered in stages. 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 is shown in “Collaring Amazon.”
Amazon closed on this chart at $967.54 per share. A collar opened at this point would be designed to combine a covered call with a long put. This accomplishes two goals: It generates income from the call while paying for the put. And the put hedges the downside risk. As of this closing date, the following options could be opened with expiration in nine days:
SELL 970 call at bid of 8.55
(less $5 trading fee) = $850
BUY 965 put at ask of 9.20
(plus $5 trading fee) = $925
NET debit = $75
This trade accomplished the two goals: Selling a covered call for income, and using that income to hedge downside risk. The collar costs $75, which is minimal considering its advantages. Below the adjusted basis in the put of $890 (strike of 965 less net cost of the collar of $75), all risk is eliminated.
If the stock price as of expiration is lower than the short call’s strike of 970, it will not be exercised. If the price is also above the put’s strike of 965, the put expires worthless. So this defensive trade provides low-cost protection for $75. It becomes valuable if and when the price falls below the put’s net basis of $890. In that case, every dollar of loss in the stock is offset by a dollar gained in the value of the put.