Collar
Components
Long underlying stock/future
Short OTM call option
Long OTM put option
Risk / Reward
Maximum Loss: Limited to the difference between the two strikes less the net premium paid or received less the loss on the stock leg.
Maximum Gain: Limited to the difference between the two strikes plus the net premium paid or received plus the gain on the stock leg.
If the net premium is a credit, i.e. you received money for the option legs, then your maximum gain is the difference between the strikes plus this amount (and then plus the profit from the stock leg). If the net premium was a payment then it is subtracted from the strike differential.
Characteristics
As you can see from the above payoff chart, a collar behaves just like a long call spread.
It is suited to investors who already own the stock and are looking to:
- increase their return by writing call options
- minimize their downside risk by buying put options
Covered calls are becoming very popular strategy for investors who already own stock. They sell out-of-the-money call options at a price that they are happy to sell the stock at in return for receiving some premium upfront. If the stock doesn't trade above this level, the investor keeps the premium.
The problem with covered calls is that they have unlimited downside risk.
The solution to this is to protect the downside by buying an out-of-the-money put.
This increases the cost as you will have to outlay more to purchase the put and hence lowers your overall return.
Comments (10)
Peter
August 19th, 2010 at 6:02pm
Hi Phil, by the definition of a collar the options have to belong to the same expiration date. I actually do not know what this type of spread would be called. I checked Natenburg's Option Volatility and Pricing
and couldn't find it mentioned there either. I would guess that it's just a type of diagonal spread.
I'm not sure about your second question. Do you mean can you still sell call options prior to the expiration of the 6 month put option?
Phil
August 19th, 2010 at 1:38am
If the call I sell and the put I buy do not have the same expiration month, is it still a "collar"?
If I buy a six month put, can I not get the premiums on two three month calls during that time?
Peter
July 24th, 2010 at 9:17am
Optionable underlyings have more than one expiration month. For example, at the time of writing, MSFT have electronic tradable options that expire January 2012.
Anyway, the graphs are just for illustration purposes.
venkat
July 16th, 2010 at 12:21pm
how can we have 60 days left to expiration as the contracts are monthly
Peter
June 10th, 2010 at 5:55am
It's the theoretical P&L calculated with 60 days left to expiration.
JH
June 10th, 2010 at 3:35am
I don't understand the "P&L 60 days" part of the graph. Is that explained anywhere?
Peter
April 29th, 2009 at 8:22pm
Hi Sarish,
OTM = Out of the Money
ITM = In the Money
ATM = At the Money
Sarish
April 28th, 2009 at 4:18pm
What does OTM stand for? Thanks for your response:)
Admin
August 23rd, 2008 at 6:28pm
Yep, you're right Nitesh. I've changed the typo as indicated.
Nitesh
August 22nd, 2008 at 2:32am
Under components you say, that we should long OTM Put option, however under characteristics is mentioned that it is ideal for the investors who own the stock and are looking for minimise their downside risk by WRITING put option. I guess instead of WRITING put uption it should be buying the put option.
Thank you
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