Market Volatility Strategy: Collars

In finance, the term collar usually refers to a risk management strategy called a protective collar. The use of collars for other situations is less publicized. With a little effort and information, though, traders can use the collar concept to manage risk and, in some cases, increase returns. This article compares how protective and bullish collar strategies work.

This strategy is often used to hedge against the risk of loss on a long stock position or an entire equity portfolio by using index options. It can also be used to hedge interest rate movements by both borrowers and lenders by using caps and floors.

Protective collars are considered a bearish-to-neutral strategy. The loss in a protective collar is limited, as is the upside.

An equity collar is created by selling an equal number of call options  and buying the same number of put options on a long stock position. Call options give purchasers the right, but not the obligation, to purchase the stock at the determined price, called the strike price. Put options give purchasers the right, but not the obligation, to sell the stock at the strike price. The premium, which is the cost of the options from the call sale, is applied toward the put purchase, thus reducing the overall premium paid for the position. This strategy is recommended following a period in which a stock's share price increased, as it is designed to protect profits rather than increase returns.

[Collars are an excellent tactic to hedge against risk, but they require a sound understanding of options and how they work in the market. If you need a refresher on how options work, or are looking to learn some options trading strategies, Investopedia Academy's Options for Beginners course is the ideal place to start.]

For example, let's say that Jack purchased 100 shares of XYZ some time ago for $22 per share. Let's also assume that it is July and that XYZ is currently trading at $30. Considering recent market volatility, Jack is uncertain about the future direction of XYZ shares, so we can say that he is neutral to bearish. If he were truly bearish, he would sell his shares to protect his $8 per-share profit. But he is not sure, so he is going to hang in there and enter into a collar to hedge his position.

The mechanics of this strategy would be for Jack to purchase one out-of-the-money put contract and sell one out-of-the-money call contract, as each option represents 100 shares of the underlying stock. Jack feels that once the year is over, there will be less uncertainty in the market, and he would like to collar his position through year end.

To accomplish his objective, Jack decides on a January option collar. He finds that the January $27.50 put option (meaning a put option that expires in January with a strike price of $27.50) is trading for $2.95, and the January $35 call option is trading for $2. Jack's transaction is:

• Buy to open (the opening of the long position) one January $27.50 put option at a cost of $295 (premium of $2.95 * 100 shares)
• Sell to open (the opening of the short position) one January $35 call option for $200 (premium of $2 * 100 shares)
• Jack's out-of-pocket cost (or net debit) is $95 ($200 - $295 = -$95)

It's difficult to pinpoint Jack's exact maximum profit and/or loss, as many things could transpire. But let's look at the three possible outcomes for Jack once January arrives:

1. XYZ is trading at $50 per share: As Jack is short the January $35 call, it is most likely that his shares were called at $35. With the shares currently trading at $50, he has lost $15 per share from the call option he sold, and his out-of-pocket cost, $95, on the collar. We can say that this is a bad situation for Jack's pocket. However, we cannot forget that Jack purchased his original shares at $22, and they were called (sold) at $35, which gives him a capital gain of $13 per share, plus any dividends he earned along the way, minus his out-of-pocket costs on the collar. Therefore, his total profit from the collar is ($35 - $22) * 100 - $95 = $1,205.
2. XYZ is trading at $30 per share. In this scenario, neither the put nor the call is in the money. They both expired worthless. So Jack is back where he was in July minus his out-of-pocket costs for the collar.
3. XYZ is trading at $10 per share. The call option expired worthless. However, Jack's long put has increased in value by at least $17.50 per share (the intrinsic value of the put). He can sell his put and pocket the profit to offset what he has lost on the value of his XYZ shares. He can also actually put the XYZ shares to the put writer and receive $27.50 per share for stock that is currently trading in the market for $10. Jack's strategy would depend on how he feels about the direction of XYZ shares. If he is bullish, he might want to collect his put option profit, hold onto the shares and wait for XYZ to rise again. If he is bearish, he might want to put the shares to the put writer, take the money and run.

As opposed to collaring positions individually, some investors look to index options to protect an entire portfolio. When using index options to hedge a portfolio, the numbers work a bit differently but the concept is the same. You are buying the put to protect profits and selling the call to offset the cost of the put.

Not so commonly discussed are collars designed to manage the type of interest rate exposure present in adjustable-rate mortgages (ARMs). This situation involves two groups with opposing risks. The lender runs the risk of interest rates declining and causing a drop in profits. The borrower runs the risk of interest rates increasing, which will increase his or her loan payments.

OTC derivative instruments, which resemble calls and puts, are referred to as caps and floors. Interest rate caps are contracts that set an upper limit on the interest a borrower would pay on a floating-rate loan. Interest rate floors are similar to caps in the way that puts compare to calls: They protect the holder from interest rate declines. End users can trade floors and caps to construct a protective collar, which is similar to what Jack did to protect his investment in XYZ.

The bullish collar involves the simultaneous purchase of an out-of-the-money call option and sale of an out-of-the-money put option. This is an appropriate strategy when a trader is bullish on the stock but expects a moderately lower stock price and wishes to purchase the shares at that lower price. Being long the call protects a trader from missing out on an unexpected increase in the stock price, with the sale of the put offsetting the cost of the call and possibly facilitating a purchase at the desired lower price.

If Jack is generally bullish on OPQ shares, which are trading at $20, but thinks the price is a little high, he might enter into a bullish collar by buying the January $27.50 call at $0.73 and selling the January $15 put at $1.04. In this case, he would enjoy $1.04 - $0.73 = $0.31 in his pocket from the difference in the premiums.

The possible outcomes at expiration would be:

1. OPQ above $27.50 at expiration: Jack would exercise his call (or sell the call for a profit, if he did not want to take delivery of the actual shares) and his put would expire worthless.
2. OPQ below $15 at expiration: Jack's short put would be exercised by the buyer and the call would expire worthless. He would be required to purchase the OPQ shares at $15. Because of his initial profit, the difference in the call and put premium, his cost per share would actually be $15 - $0.31 = $14.69.
3. OPQ between $15 and $27.50 at expiration: Both of Jack's options would expire worthless. He would get to keep the small profit he made when he entered into the collar, which is $0.31 per share.

In summary, these strategies are only two of many that fall under the heading of collars. Other types of collar strategies exist, and they vary in difficulty. But the two strategies presented here are a good starting point for any trader who is thinking of diving into the world of collar strategies.