Construction: Long 100 shares of stock, simultaneously buy one out-of-the-money put and sell one out-of-the-money call. The position has limited gains and limited losses.
Function: Provide no-to-low cost profit protection for a long stock position. The sale of the call is done to offset the cost of the put. By selling the call, you’re giving up some of the upside gains in the stock in exchange for buying the put, which insures against downside losses, for little to no cost.
Bias: Cautious or even short-term bearish.
When to Use: When you feel that your long stock position may run into a tough period of time, perhaps through earnings, but you want to keep the position.
Breakeven: The sale of the call and purchase of the put will usually create a net debit or credit. (In some cases, it can be established for zero cost.) The breakeven point is the stock purchase price minus the credit or plus the debit.
Max Gain: Gains are made at expiration at expiration for all stock prices above the breakeven point. Your maximum gain is limited by the call strike. The maximum gain equals the call strike minus the breakeven point.
Max Loss: Losses are realized at expiration for all stock prices below the breakeven. Your maximum loss is limited by the put strike. The maximum loss equals the breakeven point minus the put strike. The maximum gain plus the maximum loss will equal the difference in strike prices.
Key Concepts: Collars are not designed to make a lot of money. They are designed to provide downside protection, similar to the Protective Put strategy, but at a much lower price. By using the Collar, your main goal is to limit the downside risk, but you’re doing so by giving up some of the potential gains by selling the call. The sale of the call provides the cash to offset the cost of the put.
Example: Buy 100 shares of stock at $50. Sell one $55 call for $2, and buy one $45 put for $1. The net credit is the one-dollar difference. Depending on the strikes, the trade may result in a debit or a credit. Either way, the sale of the call reduces the put’s cost. Because this example is a one dollar credit, your breakeven point is reduced by one dollar to $49. Losses result for all stock prices below $49 at expiration. The maximum loss is $4 and occurs at the $45 put strike. It’s a $4 loss since your breakeven point is $49 but you can sell your shares for the $45 strike. Gains are made for all stock prices above $49. The maximum gain is $6 and occurs for all stock prices above the $55 call strike. With a cost basis of $49, selling your shares at $55 results in a maximum $6 gain. By selling the call, you’re sacrificing potential upside profits in exchange for receiving money to buy insurance to limit the downside risk. Note that the $4 maximum loss plus the $6 maximum gain must equal the $10 difference in strikes. The Collar’s profit and loss chart is identical to the Vertical Bull Spread.