Protective Collar Provides Downside Protection

The protective collar is an options trading strategy used by many money managers and professional investors. The collar for options can be defined as a position that protects an asset by purchasing a put with an exercise price lower than the price of the asset while simultaneously financing the purchase of the put by selling a call at a higher exercise price. For interest rate options, the put is a floor, and the call is a cap. This is how mortgage banks protect a loan. The collar strategy can be employed at the same time as buying the asset or can be employed to protect the asset after it has been purchased.

Let’s use an example: buy the S&P 500 index at 1050 and purchase a protective collar. The collar would be comprised of a put with an exercise price below 1050. Let’s say it is 1000, and the price of the put is 5.00, equaling a premium of $500. We simultaneously write the call option, which would be greater than 1050. Let’s say it is 1075, and the premium is also equal to $500. This gives us a net zero cost for the outlaying of the options strategy and gives us a maximum profit of 25 index points (1075 to 1050) and a maximum loss of 50 index points (1050 to 1000).

Exercise Price

The exercise price, also known as the strike price, is the price at which a buyer of an option has the right to sell or buy, depending on whether it is a put or a call. The reason we purchase a put that is lower than the current stock price is to protect the position from a downfall. We have the right to sell at a stated price, in this case, 1000 for the S&P 500. On the other side of the trade, we have a ceiling set by writing the call option, which means we cannot profit above a certain point, in this case, 1075.

Put Option

The put option is probably the most important part of the protective collar. This is what secures the overall position. Because generally the put price is higher than the call price of an equidistant proportion, there will be a higher cost to the collar in order to create a profit-to-loss ratio that is higher. In our example, the profit-to-loss ratio is less than 1, but the collar was free. It didn’t cost us anything to initiate the strategy.

Call Option

It’s most desirable for the call option to be high in price because that way more of the put option is financed by writing the call. That means, essentially, that this strategy is most favorable when call options are more richly priced in relation to put options. To reiterate, this protective collar strategy can be put at the same time one buys the stock or after the position has experienced gains for protection.

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