Collars have 2 main uses, either to hedge a stock you already own (Equity Collar) or to enter a new strategy to profit from the move of an underlying security. At Option Select, we concentrate on creating profit from a directional share price move without owning the share. This discussion will assume no shares being held. Depending on what strikes a trader uses, a collar can be neutral, bearish or bullish.
The Strategy The Bull collar strategy consists of buying a call and selling a call (for a bear collar buy a put and sell a put). If a collar is entered with approximately the same distance between the underlying and the options, it can be done for virtually no money down. That is, the purchase (sale) price of the call exactly offsets the sale (purchase) price of the put so the spread is a costless collar, or
Zero Cost Collar. However, collars can also be placed using strikes that aren't equidistant from the stock.
The best way of explaining how this works is by running through a Bull Collar strategy we implemented on News Corporation (NWS) last year when the share price of NWS was $21.60 and we had a positive outlook on the stock;
- We sold NWS July $21.00 puts for $0.45 and bought NWS July $22.00 calls for $0.57, resulting in a net debit of $0.12. As can be seen, the price was not equidistant, resulting in the cost of the call being more than the price received for the put.
- We exited the suggestion a few days later by selling the calls back for $0.94 and buying back the puts for $0.20, netting $0.74.
Given we paid $0.12 to enter the spread and received $0.74 to exit the spread, the return was $0.62, or 61.7% return. Even though this was a very good return collars are generally regarded as a conservative strategy.
The key to implementing the collar strategy is selecting the appropriate put and call combination that allows for profit while providing enough room to be protected from being assigned on the written leg. Of course it is possible to roll (buy back the sold leg and sell another leg) the written leg, if indeed in becomes in-the-money and becomes at risk of exercise.
Risk - Reward Characteristics The Bull collar is similar to being Long Stock (the underlying security), the spread's upside potential is unlimited (beyond the upper strike price). Losses are unlimited (below the lower strike price) because the investor could end up with a long stock position if assigned on the short Put.
Break-even Point: for Bull Collar is Higher strike price + premium in call – premium in puts and for the Bear Collar Lower strike price + premium in puts – premium in call.