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A collar can be established by holding shares of an underlying stock, purchasing
a protective put and writing a covered call on that stock. The option portions
of this strategy are referred to as a combination. Generally, the put and the call are both
out-of-the-money when this combination is established, and have the same expiration month.
Both the buy and the sell sides of this spread are opening transactions, and are always
the same number of contracts. In other words, one collar equals one long put and one written
call along with owning 100 shares of the underlying stock. The primary concern in employing
a collar is protection of profits accrued from underlying shares rather than increasing
returns on the upside.
MARKET OPINION: Neutral, following a period of appreciation.
An investor will employ this strategy after accruing unrealized profits from
the underlying shares, and wants to protect these gains with the purchase of a protective
put. At the same time, the investor is willing to sell his stock at a price higher than
current market price so an out-of-the-money call contract is written, covered in this case by the
underlying stock.
This strategy offers the stock protection of a put. However, in return for
accepting a limited upside profit potential on his underlying shares (to the call's strike
price), the investor writes a call contract. Because the premium received from writing the call can
offset the cost of the put, the investor is obtaining downside put protection at a smaller net cost
than the cost of the put alone. In some cases, depending on the strike prices and the expiration
month chosen, the premium received from writing the call will be more than the cost of the
put. In other words, the combination can sometimes be established for
a net credit - the investor receives cash for establishing the position. The investor keeps the cash credit, regardless
of the price of the underlying stock when the options expire. Until the investor either exercises
his put and sells the underlying stock, or is assigned an exercise notice on the written
call and is obligated to sell his stock, all rights of stock ownership are retained.See
both Protective Put
and Covered Call strategies presented earlier in this section of the site.
This example assumes an accrued profit from the investor's underlying shares
at the time the call and put positions are established, and that this unrealized profit
is being protected on the downside by the long put. Therefore, discussion of maximum loss
does not apply. Rather, in evaluating profit and/or loss below, bear in
mind the underlying stock's purchase price (or cost basis). Compare that
to the net price received at expiration on the downside from exercising
the put and selling the underlying shares, or the net sale price of the
stock on the upside if assigned on the written call option. This example
also assumes that when the combined position is established, both the
written call and purchased put are out-of-the-money.
Call's
Strike Price + Net Credit Received for Combination
or
Call's Strike Price - Net Debit Paid for Combination |
Put's
Strike Price + Net Credit Received for Combination
or
Put's Strike Price - Net Debit Paid for
Combination
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If the underlying stock price is between the strike prices of the call and
put when the options expire, both options will generally expire with no value. In this case,
the investor will lose the entire net premium paid when establishing the combination, or keep the
entire net cash credit received when establishing the combination. Balance either result with
the underlying stock profits accrued when the spread was established.
In this example, the investor is protecting his accrued profits from the
underlying stock with a sale price for the shares guaranteed at the long put's strike
price. In this case, consideration of BEP does not apply.
Volatility Increases: Effect Varies
Volatility Decreases: Effect Varies
The effect of an increase or decrease in
the volatility of the underlying stock may be noticed
in the time value portion of the options' premiums. The net effect on
the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money,
and the time remaining until expiration.
Passage of Time: Effect Varies
The effect of time decay on this strategy varies with the underlying stock's price level in
relation to the strike prices of the long and short options. If the stock
price is midway between the strike prices, the effect can be minimal. If the stock price is closer
to the lower strike price of the long put, losses generally increase at a faster rate as time passes.
Alternatively, if the underlying stock price is closer to the higher strike price of the written
call, profits generally increase at a faster rate as time passes.
The combination may be closed out as a unit just as it was established as
a unit. To do this, the investor enters a combination order to buy a call with the same contract
and sell a put with the same contract terms, paying a net debit or receiving a net cash credit
as determined by current option prices in the marketplace.
If the underlying stock price is between the put and call strike prices when
the options expire, the options will generally expire with no value. The investor will retain
ownership of the underlying shares and can either sell them or hedge them again with new option contracts.
If the stock price is below the put's strike price as the options expire, the put will be
in-the-money and have value. The investor can elect to either sell the put before the close of the
market on the option's last trading day and receive cash, or exercise the put and sell the underlying
shares at the put's strike price. Alternatively, if the stock price is above the call's strike
price as the options expire, the short call will be in-the-money and the investor can expect assignment
to sell the underlying shares at the strike price. Or, if retaining ownership of the shares is
now desired, the investor can close out the short call position by purchasing a call with the same contract
terms before the close of trading.
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