What is an options collar strategy? Have you considered hedging a long-term investment through impending volatility? Whether you are investing in a position for dividends or growth, you’ll eventually discover a need for a hedging strategy. Enter the options collar strategy. Options are a great way to make money trading large-cap stocks. All while saving a little money. However, it’s not as magical as it seems. Options are wasting assets. As a result, you need to know how to trade them properly.
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There are many ways to hedge a position. For example, you could pay a premium to buy a protective put, sell a covered call, or even buy an equivalent value of an inverse ETF in the sector that your position is in. You could do any of these and more for a price, but what if you could hedge your position with a known limited loss like a protective put and receive a credit?
It sounds too good to be true. But it is true. The only catch is that you must learn a little about options and how they can work for you first.
We will start with the basics. Options trading for dummies, part 1, if you will. Understanding the moving parts helps immensely.
Call Options
A call option is a contract with a specific expiration date and strike price. The contract gives the buyer the option but not the obligation to buy 100 shares of the specified stock at the strike price on or before the expiration date. As a result, the buyer pays a premium to the seller for the contract.
A call option contract originator (seller) must sell 100 shares of the specified stock at the strike price on or before the expiration date. The buyer pays the option seller a premium for the contract. So, how do call options make up the options collar strategy? Read on.
Put Options
A put option is a contract with a specific expiration date and strike price. The contract gives the buyer the option but not the obligation to sell 100 shares of the specified stock at the strike price on or before the expiration date.
As a result, the buyer pays a premium to the seller for the contract. A put option contract originator (seller) must buy 100 shares of the specified stock at the strike price at any time on or before the expiration date. Therefore, the buyer pays the option seller a premium for the contract. Are puts a part of the options collar strategy? We’ll dive into that more later.
The originator (writer) and buyer can trade both put and call options before expiration. That means you can write options and buy them back at any time.
A trader or investor who is long an option will buy to open a position and sell to close a position. A trader or investor short of an option will sell to open and buy to close a position.
You are selling short options, which results in a credit to your account, and buying long options, which results in a debit.
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Options Lingo to Understand
Call options with strikes below the current share price are “in the money.” They’re above or equal to the share price and are “at the money.
Ones that strike or exceed the share price are “out of the money.” They’re abbreviated as ITM, ATM, and OTM.
Ones with strikes above the current share price are “in the money.” Put options equal to or one strike below the share price is “at the money.
Put options that are one strike or more below the share price are “out of the money.” The Same abbreviations apply to ITM, ATM, and OTM.
Short options are known as “sell to open” or STO. Closing a short option requires buying the option back, known as “buy to close” or BTC.
On the contrary, long options are known as “buy to open” or BTO and closed when sold or “sell to close” STC.
Have you got the basics down? Good, now we can get to the meat and potatoes.
What Is an Options Collar Strategy?
The options collar strategy is simply selling to open an out-of-the-money covered call for every 100 shares of held stock while buying an out-of-the-money protective put option with the same expiration date as the call.
Both options are out of the money, but the spread between the strikes and the number of strikes out of the money will determine whether you enter a net debit or net credit position.
One would prefer to enter a net credit position. However, it depends on the cost of your long stock position and how much you will lose if you sell your position by exercising your put option(s) to protect your capital.
Or how much profit are you comfortable making on your long position if your short call option(s) are exercised? In either case, a net credit will offset losses or bolster profits.
To enter the collar with a credit, you’ll likely have to sell the call a strike or two closer to the money than the long put. This is because puts are usually a little more expensive than calls.
The put seller must assume more risk than a call seller. As a result, the premium for puts will always be somewhat greater than the premium for calls.
If your cost basis on your long stock position is between the two strikes and close to the current share price, your hedge in the collar strategy should have a maximum loss within your risk tolerance from your initial trading plan.
However, there is a bit of a drawback. Your profits will be limited if you’re assigned to the covered call(s).
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Scenarios of a Successful Collar Strategy
In an ideal situation, the expected volatility you are hedging against passes, and the share price stays within your strikes in the spread. Often, when this happens, you can close the position with a small profit and keep your long stock position.
In a worst-case scenario, you are assigned on your covered call, and your long put expires worthless. Although you received a net credit when opening the position, you’ll want to close your long put to preserve as much credit as possible. You still win in the worst-case scenario because you get to exit the trade with profit.
Here is the situation where the hedge does its job. The share price tanks far below your long put(s), forcing you to exorcise it before expiration. CLOSE THE COVERED CALL(S) FIRST!!!
This will protect you from entering a short position with unlimited risk. If you were to exercise your put(s) without closing the covered call first, you’d have a naked call.
If the share price were to bounce back right after you exercised the put(s) and go above the strike price of the call(s), you’d experience loss. Because you no longer have shares on hand to cover the call assignment.
You could also just let the options expire. Most brokers will exercise the put(s) for you and close the call(s). But I read their policy to know for sure.
It’s also a good idea to open the collar strategy with an expiration date of at least one month beyond the expected volatility event. This will make early assignments on your short option(s) much less likely. It’s unnecessary to have expiration much further than that unless you expect a longer period of volatility.
Key Takeaways
- The objective is to hedge against volatility.
- The options collar strategy does potentially limit your profit on your position while hedging potential losses.
- Early assignments can happen on a short option. Be prepared to take action and close your long option.
- It’s important to manage the collar strategy. Remember, it’s not necessarily a set-it-and-forget-it position.
- It’s also important to practice a paper trading strategy to understand how to manage it before using it in a live position.
- With an advanced options strategy like this, you won’t fall victim to FOMO trading.
Final Thoughts: Options Collar Strategy
One of my favorite things about options is their ability to make money in any market. As a result, there’s always a way to make money, even with the market trading sideways.
An options collar strategy is another way to make a profit. Practice trading them before using real money! The best broker for options trading will allow that.
Frequently Asked Questions
Options collars are worth it. They protect you from risk with a good upside.
It depends on your end goal. Options strategies allow you to make money in any market. Collars are good if you're in a bullish trade but want to protect it from risk.
The high volatility that you hadn't considered is the risk of an options collar.
