What is the Protective Collar Strategy?
The protective collar strategy is where you buy the shares of a certain security then, you sell a short call option and at the same time buy a long put option to limit the downside risk. This strategy protects the stocks from a low market price.
It uses Out of the Money on Call options when sold and a Put option when purchased.
**Both must have the same expiration date and number of shares.**
Before I dive too deep here is some review for beginners:
Strike price – a price of the share agreed and exercised between the buyer and the seller
Market price – current price of the share in the stock market
Out of the Money means the following:
Call option (you are the one who paid the option premium to buy the share)
You will lose the premium money and lose the opportunity to earn profit when the strike price (SP) is still higher than the market price (MP) on the expiration date
Out of the Money Call option = SP > MP
Put option (you will pay the option premium to sell the share at a strike price, but you don’t have an obligation to buy the share on the expiration date)
It is the opposite. You will lose the option premium money you paid. The strike price is lower than the market price on the expiration date.
Out of the Money Put Option = SP < MP
Step by Step for the Protective Collar Strategy
Long stocks + Long Put Option + Short Call option = Collar
Long stocks in options trading where an investor bought an underlying asset like shares believing that the investor will earn in the future unlike in short stocks where the investor does not own the stocks.
Short stocks are owned by someone else and the investor must settle the obligation.
Long Put Option is buying shares believing that the market price will be less than the Put strike price on expiration.
The investor owns the shares.
Short call Option – selling the existing Call option once the holder thinks that the market price will decrease below the Call strike price.
The holder will gain profit.
Since the holder does not own these shares, he or she will buy these again later when the price falls and will pay the owner of the shares.
How the Protective Collar Trading Strategy Works
Before we proceed to an actual market price example, let’s just understand this simple example first.
You bought 100 shares of ILY company at 60 per share and currently, the market price is 80 per share.
You will gain 20 per share (80-60) or 2,000 (100*20) when you sell the shares.
A Long put option strike price is 75, which you have to pay 1.5 per share or (1.5 x 100 shares = 150) according to the contract.
It is good to take the long put option if you think the market price will decrease continuously and you do not want to lose money further that is why you want to limit your loss or risk.
The question is, how will you get the money (1.5 x 100 shares = 150) for buying the Long put option?
This is the time when you will sell a Short call option.
The buyer of the short call, just like in the usual call option, has the right but is not obliged to buy the shares you are selling at expiration date.
The strike price for the short call you are selling is 85, which you will earn 1.9 per share or (1.9 * 100 shares) 190. The net premium you will get is 0.40 per share (1.9-1.5) or 40 (190 earned from short call option – 150 pay for a long put option).
Here is a visual representation of the protective collar payoff:
Try to imagine that the graph looks like a collar when you color or shade the Put/loss side and the Call/profit side. 🙂
80 is the current market price
Breakeven for profit and loss is 1.90 at 85 and -1.5 per share at 75
Breakeven market price:
60 share price when you bought the stocks in the first place + 1.5 – 1.9 = 59.6
EARN if market price at expiration date is equal or more than the strike price of the Call (85)
LOSS if market price at expiration date is equal or below the strike price of the Put (75).
Case # 1: Market price at expiration date is $70 (below $80 current market). How much is your total earnings or loss (excluding commissions/fees and taxes)?
You can still exercise the put option at 75 strike price and when the investor buys the shares, you will gain 15 (75-60). Regarding call option, you will gain nothing. The investor will just let the shares expire since the strike price of 85 is more expensive than the market price of 70.
You also gained the net premium of 0.40 so the total earnings you will receive is 15.40
Case # 2: Market price at expiration date is $100 (above $80 current market price)
You will exercise the call option at 85 strike price since the investor will still probably buy from you. This is only a short call option and you do not own the shares, the difference of 5 (85-80) will go to the owner of the shares.
No worries, you still have earnings because aside from the 20 per share you gained from 200 ILY shares (80-60) and the net premium of 0.40.
Total earnings you will receive is 20+0.40 = 20.4
Case #3: Market price at expiration date is $80 or $80.50, meaning no or almost no movement at all.
You will just gain the net premium of 0.40. The investor will just decide to buy normally in the stock market instead of buying the call. You will also not sell the put either.
Case #4: Market price at expiration date is $59.6
This is the breakeven market price and is not profitable since it is lower than your original 60 per share and also lower than the strike prices. The options will just expire. You will just earn the net premium of 0.40 (Call premium of 1.9 – Put premium of 1.5)
The good thing about protective collar is you can still earn the net premium even the market price falls below 59.6.
Protective Collar Trade Example with APPLE INC.
Now let’s do an actual market price example to further demonstrate the protective collar strategy.
Let’s say you went ahead and bought 100 shares of APPLE INC. at 168.37 per share.
A total of 16,837 (100 shares * 168.37)
2.9 earned premium from call – 2.5 paid premium for put = 0.40 net premium
170 call strike – 168.37 market price +.40 net premium = 2.03
165 put strike – 168.37 market price + .40 net premium = -2.97
Break-even market price:
168.37 share price +2.5 paid premium -2.9 earned premium from call = 167.97
At expiration date, the market price is 180. This means there is a 10 gain from call option when the investor buys the shares (180-170) but you will pay this to the owner of the shares you are selling.
Your earnings are 12.03 (180-168.37+0.4 net premium)
In case the expiration date market price is equal or below 168. You will earn 0.4 net premium. Not much gain when selling the shares. Options will just expire because you purchased the APPLE INC. shares at 168.37.
If the market price at expiration date is 169. You can still exercise the put option at 165 strike price and when the investor buys the shares, you will gain 15 (169-168.37). Regarding call option, you will gain nothing. The investor will just let the shares expire since the strike price of 170 is more expensive than the market price of 169.
Pros of Protective Collar Strategy:
This strategy is cheaper than buying only a protective put where you have to shell out your own money from other shares or other sources.
When market price is lower than strike price, you can gain additional profit whether the investor will buy these at strike price or the investor let these expire and you will sell these again later depending on the market price.
Cons of Protective Collar Strategy:
When the stock price increases and performs well, profit is now limited within the collar
You have an obligation to the owner of the Short call you sell to an investor
This strategy is good for protecting your gains from stocks against declining market prices but in exchange of a limited profit unlike in other strategies where you can earn unlimited profit but with unlimited or huge risk as well.
To establish a collar, you will just have to shell out little to zero cost up front.
Good luck with your trading and minimize your risk wisely.