Collar (Trade Strategy) - Explained
What is a Collar?
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What is a Collar?
A collar is a strategy sued in trade and investment to reduce large losses by setting a limit to the possible gains and losses that can be incurred in an investment. A collar strategy is also called a hedge wrapper, this strategy allows an investor lock in the highest gain and highest loss of investment. An investor creates a collar by purchasing stock and protective (out-of-the-money) puts option and simultaneously sell an out-of-the-money call option. While a collar strategy helps investors prevent huge losses, it also limits their gains in investment.
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How Does a Collar Work?
When a collar is used as a strategy to hedge huge losses in an investment, a trader must hold shares of the underlying stock then buy a protective put option and at the same time sell a call option. Generally, investors activate the collar when they are bullish on a stock over a long period or when significant profit has not realized on the long stock held. When a collar strategy is implemented, it helps an investor protect the realized gains from a downside move. When the protective collar is activated, two strategies can be used, these the protective put and covered call. Both collar strategies hedge against huge losses in investment but at the same time limit the profit that can be made from an investment. Collar Break Even Point (BEP) and Profit Loss (P/L) The break-even point (BEP) and the profit/Loss (P/L) are important terms in the collar strategy. The break-even point is realized by subtracting the net of premiums paid and received for the put and call from the price at which the underlying stock was purchased. The underlying stock can either be purchased at credit or debit. Hence, BEP is calculated using any of the formulas below;
- BEP = Underlying stock purchase price + Net debit
- BEP = Underlying stock purchase price - Net credit
The maximum profited a collar is however calculated as an equivalent of the strike price of the call option. The formula below is used;
- Maximum Profit = (Call option strike price - Net of Put / Call premiums) - Stock purchase price
On the other hand, the maximum loss is calculated as the purchase price of the underlying stock less than the strike price of the put option. This loss is calculated as;
- Maximum Loss = Stock purchase price - (Put option strike price - Net of Put / Call premiums)