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When investing in options trading, there are a handful of option trading strategies to choose from: Straddles, the Iron Condor, LEAPS, and more.
There is one options trading strategy that can help you limit your losses if the stock price drops while still allowing you to participate in any upside potential the stock may have.
Sound too good to be true?
We’re talking about Collar Options.
If you’re new to Collar Options, or you’re looking to brush up on your education of the strategy, we’ll discuss everything you need to know in this article.
What are Collar Options?
The collar options trading strategy is when an investor buys an out-of-the-money call option and finances it by selling an out-of-the-money put option.
The idea behind the collar options strategy is that the investor can potentially make a profit if the stock price goes up while simultaneously limiting their downside risk if the stock price falls.
Collar options can be a great way to protect your portfolio from downside risk while still allowing you to make some profits if the stock price goes up.
Let’s take a closer look at the advantages and disadvantages of the collar options strategy.
Advantages of Collar Options
There are a few key advantages to using a collar options trading strategy.
- It can help to minimize risk. By buying a call option and selling a put option at the same time, you can help to offset any potential losses.
- It can be a relatively low-cost way to trade. Collar options strategies typically involve buying and selling options with different strike prices, so you're not paying full price for both options.
- It can be a flexible strategy that allows you to take advantage of market volatility. You can adjust the strike prices of the options depending on your bullish or bearish outlook.
Ultimately, whether or not a collar options trading strategy is right for you will depend on your individual trading goals and risk tolerance.
But for many traders, it can be an effective way to limit downside risk while still allowing for upside potential.
Disadvantages of Collar Options
One potential disadvantage of using a collar options trading strategy is that it may limit your upside potential.
When you buy a stock, you have the potential to make a profit if the stock price goes up.
However, when you enter into a collar trade, you give up some of that upside potential in exchange for protection against downside risk.
As a result, you may miss out on some profitable opportunities if the stock price rises more than you anticipated.
Another potential downside of collars is that they typically require frequent monitoring to be successful — it's not passive income.
This is because the price of the underlying security can move very rapidly, and you need to be sure that your position remains profitable.
If you don't have the time or resources to commit to this level of monitoring, then a collar strategy may not be right for you.
Example of Collar Options
Let’s look at a quick example of a trade using a collar options trading strategy.
Let's say you believe strongly that the stock price of ABC Company, currently trading at $100 a share, will drastically increase in the next few months.
In this case, you could purchase a $105 strike price call option and sell a $95 strike price put option.
If you are correct in your assumption and the stock price increases, you could sell your call options at a profit, to add to the net premium you collected on the put options.
However, if your belief in the stock price is wrong, your call options would expire worthless, but the profits from the put options would help to offset that to some degree.
Collar Options: Factors to Consider
Now that we’ve explained what the collar options strategy is as well as its advantages and disadvantages, let’s dive even further into the options strategy by looking at its expiration, volatility, potential profit, and potential loss.
Breakeven at Expiration
There are two potential breakeven points for a net credit collar options trading strategy.
This is determined based on if the trade is opened with a net credit or net debit.
Net Credit
The breakeven point is determined by taking the current stock price and subtracting the net credit.
Net Debit
The breakeven point is determined by taking the current stock price and adding the net debit.
Implied Volatility
When it comes to collar options trading, implied volatility is one of the key things to keep an eye on.
That's because, as implied volatility goes up, the price of options tends to increase as well. And since the cost of buying one option is typically offset by the premium collected from selling another in a collar trade, an increase in the price of either one can have a big impact on the overall strategy.
In general, higher implied volatility means higher risk and potential reward, so it's important to understand how it might impact your trade before you enter into it.
With that said, implied volatility is just one factor to consider in any options trade.
Maximum Potential Profit
A trade involving collar options can be established with a net credit or net debit, depending on the strike prices of the call and put used in the trade.
Net Credit
The strike price of the call option, minus the stock price, plus the net credit of the put option determines the maximum profit in this trade.
Net Debit
The strike price of the call option, minus the stock price, minus the net debit of the put option determines the maximum profit in this trade.
Ultimately, a trader would like the price of the underlying stock to be as high as possible to maximize profits with this trading strategy.
Maximum Potential Loss
The put option in a collar options trading strategy limits the maximum potential loss in an options trade.
However, this looks slightly different when a trade is open with a net credit or net debit.
Net Credit
A maximum loss is determined by taking the stock price, subtracting the put strike price, and adding the net credit received when the trade was opened.
Net Debit
A maximum loss is determined by taking the stock price, subtracting the put strike price, and also subtracting the net debit paid when the trade was opened.
The fact that potential losses are limited sometimes allows traders to wait for the underlying stock to rebound before exiting the trade.
When You Should Use a Collar Options Strategy
The collar options trading strategy is a great way to protect your downside while still allowing for upside potential.
Here's a rundown of when you should use the collar options strategy:
- When you are buying shares of a stock that you believe to be undervalued, but you are worried about a potential market correction in the short term.
- When you own shares of a stock that has recently reached new highs and you want to lock in some profits, but you are still bullish on the stock in the long term.
- When you are looking to hedge against potential downside risk in a portfolio or index.
When You Should Not Use a Collar Options Strategy
There are a few times when it's not ideal to use the collar options trading strategy.
- One is when the options market is very flat. In other words, when there isn't a lot of movement in the prices of options.
- Another time is when you expect the stock price to make a big move soon. Since the collar caps your upside, you don't want to miss out on potential profits.
- If you're only planning on holding the stock for a short period, it may not be worth the trouble of setting up a collar. Collars can be complex to set up, so if you're only going to hold the stock for a few weeks or months, it might not be worth it.
The Bottom Line: The Collar Options Trading Strategy
Collar options are a great tool to have in your options trading arsenal, but they are not for everyone.
There are multiple variations of collar options that allow you to create net zero, net debit, or net credit to open a trade.
If you understand when and how to use them, collar options can be a powerful way to protect your profits while also limiting your losses.
However, always remember that while this is an excellent options trading strategy, no options trading strategy is foolproof, so make sure you do your research before implementing any trade.
Armed with this knowledge, you can make more informed choices about which options trading strategy is right for you.
