A protective collar is a popular options strategy used to serve as a form of protection against loss on the downside while retaining the possible profit on the upside. A protective collar is usually used by a trader holding a big position in an underlying instrument such as a stock and would prefer to hedge against additional loss or trim it. The protective collar is formed by going long on the asset, purchasing a put option to obtain protection on the downside, and selling a call option to generate revenue to assist with funding the put.
The protective collar is quite literally an insurance policy of a sort on the underlying asset. The bought put option guarantees that if the asset price drops below a certain level, the investor can sell the asset at the particular price, thus capping losses. The sold call option, on the other hand, generates premium revenue, which offsets the cost of buying the put, thus lowering the cost of the strategy. But at the expense of a cap on the profit potential—the profit potential is capped by the strike of the call sold.
When the asset price goes above the call option strike, the investor has to sell the asset at this price and hence cap additional profit. For instance, if the investor owns 100 shares of a stock that is worth $50 per share, the investor can utilize a protective collar by buying a put option with a strike price of $45 and selling a call option with a strike price of $55. In that scenario, if the stock price falls below $45, the investor can sell his or her share at that price to avoid further loss. The investor will be compelled to sell his or her share at that price if the share price increases up to $55, thus capping his or her potential profit.
The protective collar strategy is the most appealing to those investors who would want to hedge their position against sudden market downturns without actually selling their holdings. It is typically employed by long-term investors who have high expectations of the future of an asset but do not want to subject the value of their position to the possibility of a steep market fall. By using a protective collar, investors can build a less risky risk-adjusted portfolio and still enjoy potential upside activity.
A further benefit of the protective collar is its flexibility. Investors can adapt the strategy to their risk tolerance by adjusting the put and call option strike prices. For example, if the investor desires greater protection on the downside, they can buy a lower-strike put. Alternatively, if they are inclined to assume some risk for greater potential return, they can sell a call with a higher strike. This flexibility enables the investor to control risk and reward about their particular requirements.
The price of an exercise of a protective collar can be a function of the underlying asset value, option expiration date, and market volatility. It will be more expensive to purchase the protective put option in a riskier market, but it is possible to compensate for it with the proceeds from selling the call option. On a low-risk position, the put will be cheaper, but so will the premium received from selling the call. Thus, the net effectiveness of the collar will be a function of market conditions and how effectively the investor can reduce the strategy for his account. There are some detriments to the protective collar despite all of its positives.
The largest drawback is the cap on potential upside. By selling the call option, the investor gives up the possibility of profiting as much from an increase in the underlying asset. What it implies is that if the asset or the stock rallies well, the investor forfeits the appreciation in price above the written call’s strike price. To investors who are looking for a significant return on the underlying, this is less than a desirable trade-off.
In an extremely bullish market, the protective collar will cap a gain when the investor is prepared to share in the entire upside of the asset. However, the collar may be utilized as a wise and intelligent move for those investors who wish to cap their portfolio at the expense of lesser appreciation. This approach can even be utilized to protect gains on a holding that is witnessing a record gain in price.
For instance, if a trader has a high holding in a stock that has appreciably risen in value, he/she can utilize a protective collar to lock the gains and protect against subsequent loss. Options income strategies are methods used by investors to generate income through selling options contracts and collecting premiums.
Of the top 10 best options income strategies are the covered call, where you sell a call option on a stock you hold to earn premium income while, incidentally, perhaps selling the stock at the strike price, and the cash-secured put, where you sell a put option while holding enough cash to purchase the underlying asset in case it is exercised. This strategy enables the investor to “lock in” part of the profit while still having the potential to capitalize on any small up move without closing out the entire position. From a risk management perspective, the protective collar enables a certain and neat risk/reward profile.
