COLLAR
A Collar is similar to Covered Call (Strategy 6)
but involves another leg – buying a Put to
insure against the fall in the price of the
stock. It is a Covered Call with a limited risk. So a
Collar is buying a stock, insuring against the
downside by buying a Put and then financing
(partly) the Put by selling a Call.
The put generally is ATM and the call is OTM
having the same expiration month and must be
equal in number of shares. This is a low risk
strategy since the Put prevents downside risk.
However, do not expect unlimited rewards since
the Call prevents that. It is a strategy to be
adopted when the investor is conservatively
bullish. The following example should make
Collar easier to understand.
When to Use: The collar is a good strategy to use if the investor is writing
covered calls to earn premiums but wishes to protect
Thishimselfstrategyfrominvolvesanunexpected
sharp drop in the price of the underlying
security.
Risk: Limited
Reward: Limited
Breakeven: Purchase Price
of
Underlying
– Call Premium
+ Put
Premium
Example
Suppose an investor Mr. A buys or is holding ABC
Ltd. currently trading at Rs. 4758. He decides to establish a collar by writing
a Call of strike price Rs. 5000 for Rs. 39 while simultaneously purchasing a
Rs. 4700 strike price Put for Rs. 27.
Since he pays
Rs. 4758 for the stock ABC Ltd., another Rs. 27 for the Put but receives Rs. 39
for selling the Call option, his total investment is Rs. 4746.
Strategy
: Buy Stock + Buy Put + Sell Call
|
ABC Ltd.
|
Current Market Price
|
4758
|
|
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(Rs.)
|
|
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Sell Call Option
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Strike Price (Rs.)
|
5000
|
|
|
|
|
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Mr. A Receives
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Premium (Rs.)
|
39
|
|
|
|
|
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Buy Put Option
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Strike Price (Rs.)
|
4700
|
|
|
|
|
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Mr. A Pays
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Premium (Rs.)
|
27
|
|
|
|
|
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Net Premium
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12
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Received(Rs.)
|
|
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Break Even Point (Rs.)
|
4746
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|
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Example :
1) If the price of ABC Ltd. rises to Rs. 5100 after
a month, then,
a. Mr. A will sell the stock at Rs. 5100 earning him
a profit of Rs. 342 (Rs. 5100 – Rs. 4758)
b. Mr. A will get exercised on the Call he sold and
will have to pay Rs. 100.
c. The Put will expire worthless.
d. Net premium received for the Collar is Rs. 12
e. Adding (a + b + d) = Rs. 342 -100 – 12 = Rs. 254
This is the maximum return on the Collar
Strategy.
However, unlike a Covered Call, the downside risk
here is also limited :
2) If the price of ABC Ltd. falls to Rs. 4400 after
a month, then,
a. Mr. A loses Rs. 358 on the stock ABC Ltd.
b. The Call expires worthless
c. The Put can be exercised by Mr. A and he will
earn Rs. 300
d. Net premium received for the Collar is Rs. 12
e. Adding (a + b + d) = - Rs. 358 + 300 +12 = - Rs.
46
This is the maximum the investor can loose on the
Collar Strategy.
The Upside in this case is much more than the
downside risk.
The
Payoff schedule
|
ABC Ltd. closes
|
Payoff from
|
Payoff from
|
Payoff
|
Net payoff
|
|
at (Rs.)
|
Call Sold
|
Put Purchased
|
from stock
|
(Rs.)
|
|
|
(Rs.)
|
(Rs.)
|
ABC Ltd.
|
|
|
4400
|
39
|
273
|
-358
|
-46
|
|
4450
|
39
|
223
|
-308
|
-46
|
|
4500
|
39
|
173
|
-258
|
-46
|
|
4600
|
39
|
73
|
-158
|
-46
|
|
4700
|
39
|
-27
|
-58
|
-46
|
|
4750
|
39
|
-27
|
-8
|
4
|
|
4800
|
39
|
-27
|
42
|
54
|
|
4850
|
39
|
-27
|
92
|
104
|
|
4858
|
39
|
-27
|
100
|
112
|
|
4900
|
39
|
-27
|
142
|
154
|
|
4948
|
39
|
-27
|
190
|
202
|
|
5000
|
39
|
-27
|
242
|
254
|
|
5050
|
-11
|
-27
|
292
|
254
|
|
5100
|
-61
|
-27
|
342
|
254
|
|
5150
|
-111
|
-27
|
392
|
254
|
|
5200
|
-161
|
-27
|
442
|
254
|
|
5248
|
-209
|
-27
|
490
|
254
|
|
5250
|
-211
|
-27
|
492
|
254
|
|
5300
|
-261
|
-27
|
542
|
254
|
The
payoff chart (Collar)
|
|
+
|
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+
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=
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Buy Stock
|
Buy Put
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Sell Call
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|
Collar
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