Collars: The Ultimate Portfolio Insurance Policy

It’s time to take a quick look
at another basic option strategy. This
one is for both rookies and conservative investors.

Collars allow you to own stocks
– even when worried about a bear market – because it establishes a floor for
the value of your holdings. In other
words, you know, in advance, how much you can lose in a worst-case
scenario. Collars are flexible and you
can be certain that losses do not exceed a level you choose. As with any insurance policy, if you want
that loss (the deductible) to be very small, the cost (premium) is higher.

 

What is a collar?

A collar is a position
consisting of three parts:

  • Long stock
  • Short call option
  • Long put option

Collars are designed to
minimize the cost of buying insurance (the put option). That’s accomplished by selling a call option,
collecting a cash premium, and limiting your upside potential. But for investors who are more concerned with
preserving capital than with earning profits, this is an ideal strategy because
it allows you to do both.

To construct a collar, buy
stock, write a covered call option, and buy one put option. Because you own a put, the value of your
stock can never drop below the put’s strike price. You may choose any strike price, but as the
strike price moves higher, you must pay more for that put. No matter how far the stock declines, you
have the right to sell stock at the put strike price – and that’s how any
potential losses are limited.

To offset all or part of the
cost of buying the put, a call option is sold. As with covered call writing, choose a call option that suits your
needs. You may prefer to sell an option
that is at the money, sacrificing upside potential in return for collecting a
higher premium. You may decide to sell
an out of the money option, collecting less cash, but giving yourself the
chance for an upside profit. There is no
‘best’ collar and each of you must find appropriate options to build a position
that allows you to achieve your investing objectives and also falls within your
comfort zone.

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