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Collars: Revisited

It's time to take a fresh look at collars.  In mid-2008, we wrote about collars and how they work.  As a reminder, a collar position consists of owning 100 shares of stock, one (almost always an out of the money) put option, and being short one out of the money call option.

The purpose of owning this position is to limit losses when the market falls.  The trade is slightly bullish and there is limited upside profit potential.

This is one option strategy that is preferred by those who want to protect their holdings from a devastating market decline.  It's very effective because losses are limited (the collar owner maintains the right to sell shares at the strike price of the put he/she owns).  There are two reasons that this type of portfolio insurance is so appealing:

  • It almost always costs no cash out of pocket to own the collar.  That's true when the investor collects as much cash when selling the call option as it costs to purchase the protective put option
  • This position provides both safety and the opportunity to earn a limited profit.  Investors who only buy puts must pay the heavy cost and have little chance to earn any money, unless there is a significant rally

Experienced option traders are probably aware that owning the collar is equivalent to two other positions, each of which is a popular strategy on its own.  However, many novice traders do not recognize that they may be trading collars in a different format:

  • Selling an OTM put spread
  • Buying an ITM call spread

Example (this is an example and NOT a recommendation) 

The Traditional collar:

Buy 100 shares of AAPL, paying $300 per share [$300 is not current price]

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 call

Sell the put spread – the equivalent position:

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 put

Buy the call spread – the equivalent position

Buy one AAPL Dec 280 call
Sell one AAPL Dec 320 call

For each of these three trades:

Maximum profit occurs when AAPL is above 300 at expiration
Maximum loss occurs when AAPL is below 280 at expiration

Profit and Loss are the same for each of the three positions when the options are priced efficiently.


So What?  Who cares?

I approve of collars.  I believe they are an appropriate strategy for protecting a portfolio.  However, I know that some people adopt strategies without understanding how they work.

The point that I want to make today is that the collar looks good – and is good for the appropriate investor/trader.  However, many people who adopt collars would never sell a put spread nor buy a call spread.  Yet, they are making the identical trade.  It's important to recognize what you are truly trading.

Some collar traders would be better served by adopting one of the alternative strategies.  The margin requirement is low and trading a position with two legs is far more cost efficient than trading one with three legs. I suggest that collar traders make an effort to trade the corresponding call or put spread in place of the collar.

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