What are the characteristics of this option strategy?
Collar option strategies are popular amongst investors who hold stock and have a medium to long-term outlook on it. A collar is three positions at once: long 100 shares, a long protective put below the market and a short call above it. The put sets a floor under the shares and the call, whose premium helps pay for that put, sets a ceiling on the gain. Both the loss and the profit are therefore defined at the outset, and the goal is to protect a long stock position at little or no net premium cost.
Is this a bullish, bearish or neutral strategy?
The collar option strategy is neutral to moderately bullish, not a bearish trade. A collar is built on a long stock position: the investor owns the shares, buys a protective put below the market and sells a covered call above it, so the position stays long the stock with both ends of the payoff clipped. The mirror image on a short stock position, buying a call and selling a put, is a separate strategy known as a reverse collar. An investor who is bullish but unwilling to sit through a drawdown can collar the shares to cap that drawdown, accepting the ceiling on the upside as the price of the protection.
Is this a beginner or an advanced option strategy?
The collar option strategy is considered to be an intermediate to advanced option trading strategy. It involves the combination of a covered call and a protective put which can be difficult for an inexperienced trader to execute.
In what situation will I use this strategy?
The collar option strategy is typically used by investors who already own the stock, are still constructive on it, but want to cap the damage from a fall and are willing to give up the upside above the call strike to pay for that. Common cases are a large concentrated holding, a position sitting on a big unrealised gain, or a stretch where the investor cannot watch the market closely.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The collar option strategy sits at the low end of both risk and reward. Both ends are defined from the day it is opened: the most that can be lost is the stock price less the put strike, plus any net premium paid, and the most that can be made is the call strike less the stock price, less that premium. Note that the floor is not zero loss. A put struck 10 percent below the market still leaves roughly 10 percent of the position exposed before the protection starts.
How is this strategy affected by the greeks?
The greeks will affect this strategy to a certain extent. The collar option strategy involves a combination of a covered call and a protective put, and the value of these trades will be affected by the greeks such as delta, gamma, theta and vega.
In what volatility regime (i.e VIX level) would this strategy be optimal?
This strategy works best in a low to medium volatility regime. The put has to be paid for out of the call premium, and when volatility is high the put gets expensive faster than the call pays for it, so the investor ends up giving away more upside to fund the same floor.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting the collar option strategy when the trade goes against you can be relatively easy or difficult, depending on the situation. The protective put caps the damage below its strike no matter how far the market falls, though the loss down to that strike is still yours. If the market moves the wrong way, then the adjustment should be done by either closing out the covered call or buying a further out of the money put option to replace the one that you have.
Where does this strategy typically fall in the range of commissions and fees?
The collar involves a stock trade plus two option legs, so it carries moderate commissions and fees, more than a single-leg trade and less than a four-leg spread. The net premium cost is the larger variable: it depends on how far the put and call strikes sit from the market, and a collar can be structured for a debit, a credit or close to zero net cost.
Is this a good option income strategy?
Not really. The call premium in a collar is spent on the put rather than kept, so the usual zero cost collar produces no income at all. It becomes a net credit only when the call sold brings in more than the put costs, and widening that gap means either giving up more upside or accepting a lower floor. If income is the objective, a covered call on its own collects the full premium, at the price of leaving the downside open.
How do I know when to exit this strategy?
The collar option strategy should be exited when the underlying asset reaches the strike price of the covered call or the protective put. If the strike price is reached and the market is expected to remain at this level, then the trade should be exited. Otherwise it could be beneficial to remain in the trade as long as possible as the premiums of the options could still be beneficial.
How will market makers respond to this trade being opened?
Market makers are likely to be neutral to this trade being opened. They may try to extract additional premium from the investor by charging higher prices for the option trades, but typically the impact of this will be minimal.
What is an example (with calculations) of this strategy?
An example of the collar option strategy would be an investor buying 100 shares of a company at a price of $50 and then writing a covered call with a strike price of $55 and buying a protective put with a strike price of $45. Say the $45 put costs $2 and the $55 call brings in $2, so the two option legs finance each other exactly and the collar is put on for no net premium. Above $55 the shares are called away and the gain is capped at $5 per share, or $500 on the 100 shares. Below $45 the put is exercised and the loss is floored at $5 per share, or $500. Between $45 and $55 both options expire worthless and the profit or loss is simply the move in the shares away from $50, so the breakeven stays at $50. If the collar is set up for a net debit, subtract it from the gain and add it to the loss; a net credit does the reverse.
Conclusion
The collar option strategy trades away the upside above the call strike in exchange for a floor under the shares at the put strike. It suits an investor who already holds the stock, has a medium to long-term outlook, and would rather have a known worst case than an open-ended one. It does not remove the risk between the current price and the put strike, so where that put is struck is the decision that matters.
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Here are some templates that you can use to create your own models
Collar Option Strategy
Delta Neutral Hedging
STOCK REPLACEMENT
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Relevant blogs that you can read to learn more about the topic
Collar Option Strategy – A Synopsis
Collar Option Strategy – A Synopsis
“Maximizing Your Profits with Out of Money Call Options”
Unlock the Potential Profits of Collars Trading
Maximizing Returns with Covered Put Options