Long Collar Options Strategy: Risk Management in Options Trading

A long collar options strategy is a way to help protect your investment from big losses while still allowing for some gains. It involves buying a put option to set a minimum selling price and selling a call option to set a maximum selling price for the underlying long stock position. This strategy helps manage risk.

What Is Long Collar Options Strategy

The long collar options strategy focuses on limiting the range of possible outcomes for an investment. By buying a put option, known as a protective put, you can limit the downside risk. The call option you sell under this trade could allow you to benefit from the upside, but your gains would be capped at the level of the strike price. This part of the trade is similar to selling a covered call. If the share price rises above the strike price, the buyer of the call option can exercise the contract and you will be required to sell the underlying stock at that strike price. That limits your profit potential. The long put and short call options allow investors to create a “collar” around the stock’s price.

This strategy acts much like a collar in a sense that it acts to limit potential losses and gains. In general, the strike price for the put option sold is lower than the strike price of the call option, although the quantity and expiration date should be the same for both.

Why Consider Long Collar Strategy: How It Works

Imagine you own shares of a stock and you are worried about their price dropping. You can buy a put option, which can be equivalent to letting you sell your stocks at a set price, potentially limiting your losses. To help cover your cost, you will sell a call option, which means you agree to sell your stocks at a higher price if they go up. It’s similar to having insurance for your stocks, which may give you peace of mind to buy or hold onto the underlying shares while still allowing for some profit.

Long Collar Example

Suppose you want to own a position in a chipmaker. Let's call that company CHIP. Let's assume that CHIP is trading at $116.70. You can buy 100 shares and purchase a put option that will let you sell your shares at $116 in 30 days to protect you in case the stock price falls below that level. To limit your cost, you can sell a call option that gives the buyer the right to purchase your shares at $136 on or before its expiration in 30 days.

Here's a breakdown of the above theoretical trade:

Collar Profit and Loss

Under this example, you can make a profit if the stock price rises above the $121.57 strike price. This allows you to sell the stock at a higher price, minus the cost of the put option. However, your gains are capped at the call option’s strike price, even if the stock price rises much higher than that.

Conversely, you may incur a loss if the stock price falls. But the put option you bought can limit your losses by allowing you to sell at the put's strike price, which in this case, is $116.

Max Profit

The theoretical maximum profit you can book from a long collar options strategy is limited to the difference between the strike price of the call option you sold and the purchase price of the stock, minus the net cost of the options (the cost of the put option minus the premium received from selling the call option).

If the stock price rises above $136 at expiration, you would be required to sell your shares at $136 due to the short call option. In this case, the long put option would expire worthless. Your profit per share would equal to $14.43. Given that each option covers 100 shares, your total maximum gain would be $1,143.

Here's the calculation:

Of course, you will also need to factor in the fees charged by your broker, if any. This cap on profit is due to the short call option obligating you to sell the stock at the call’s strike price if the stock price rises above it and it is exercised.

Max Loss

The theoretical maximum loss is limited to the difference between the stock’s purchase price and the put option’s strike price, plus the net cost of the options and the fees, if any. This strategy can help protect against significant losses.

If the stock price falls below $116, you can still sell your shares at $116 by exercising the long put option. If this occurs at expiration, your loss per share is $5.57. Keep in mind that most individual option contracts cover 100 shares, so your theoretical total maximum loss would be $557.

Breakdown:

Breakeven

Breakeven is the point where you neither make a profit or incur a loss. To reach breakeven, the stock price needs to cover the initial stock purchase price plus the net cost of the options.

So, if the stock price is $121.57 at expiration, you break even on your collar options strategy.

Time Decay

Time decay, also known as theta, refers to the reduction in the value of an options contract as it approaches its expiration date.

The value of the long put option generally decreases over time due to time decay. This is because the likelihood of the stock price falling below the put’s strike price diminishes as expiration approaches, unless there is increased volatility in the market that accelerates the share price decline. Time decay works against the protective put, reducing its value.

On the other hand, the short call option benefits from time decay. As time passes, the probability of the stock price rising above the call’s strike price decreases, which lowers the value of the call option. An exception could be an extraordinary event that could send a stock price soaring. Absent those exceptional events, the erosion in option value could be beneficial for the seller of the call option.

How to Set Up Long Collar Strategy Using Moomoo

Those who don't already own the stock and want to buy shares using a long collar option strategy can follow the steps below. Please be aware that these steps will default to buying 100 shares, selling a call and buying a put.

Step 1: From the desktop app, go to the Options tab on the left side.

Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 2: You'll find the strategy tab right below the stock symbol and volume. The default is Single Option, but if you click on the arrow, it will pull up all the strategies.

Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 3: Click on collar and click on the expiration date you prefer. It will pull up the different sets of collar options you can choose from. The system can automatically help you buy 100 shares of the underlying stock, buy one put option and sell one call option, forming a long collar.

Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 4: Next to the collar tab, you'll find a selection of strike width. You can explore the options in the default spread between the strike price of the put option and the strike price of the call option. You can also click on the drop down menu and choose your preferred spread between your put and call option from the list. Of course, your cost, potential maximum loss and potential maximum gain will vary depending on the spread you choose. It's always prudent to consider market dynamics and your own investment objectives when setting up your trade.

Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Below is the example of the trade mentioned higher up in this article.

Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

When to Consider Using a Long Collar Strategy

The collar strategy can be useful in times of extreme volatility or market uncertainty. It can provide downside protection while allowing for some upside potential, making it a conservative approach to managing risk. This can be particularly appealing to those option traders who prefer a balanced risk-reward profile.

When to Consider Closing a Long Collar Strategy

The collar's effectiveness may weaken if the stock price sees a massive shift upward or downward. If the stock price rises well above the call option's strike price, the investor can close the covered call part of the trade to try to take advantage of potential further gains. In this case, the investor will likely incur a loss on the buy to close the call option and the stock may not continue to increase in price.

Monitoring market conditions and reassessing your investment goals can also signal it’s time to close. If the stock’s outlook changes significantly or the options are nearing expiration, it might be prudent to exit the strategy to lock in gains or possibly minimize losses.

If the collar has served its purpose, such as providing short-term downside protection, the investor might close it if they think the risk level no longer necessitates it.

Another thing to consider is the approaching expiration date, which can diminish the protective benefits of a collar. Closing both the put and the call option can avoid complexities associated with exercising or assignment.

In these cases, if you want to hold on to your shares, you can just close your options by selling your put and buying back your call.

Potential Pros and Cons of Collar Options Strategy

Pros: A long collar options strategy can help protect your investment. If the stock price falls, the long put option can limit your losses. But if the stock price rises, you can profit, though it may be capped by the short call option. It can be a an effective way to manage risk associated with a long stock position by using options.

Cons: The main downside is that your potential profit is limited. If the stock price soars, you won’t benefit beyond the call option’s strike price. Also, there are costs involved in setting up the strategy, which can eat into your potential returns.

Long Collar vs. Long Call Spread

A long collar strategy involves owning a stock, buying a put option to help limit losses, and selling a call option which yields a premium but may cap potential gains. It’s like setting a "safety net" and a "ceiling" for your investment.

A long call spread involves buying a call option at a lower strike price and selling another call option at a higher strike price. This strategy can profit from a rise in the stock price but may limit both potential gains and losses, as opposed to purchasing the shares outright.

In short, a collar protects an existing stock position, while a long call spread is a trade used when it is believed that the underlying stock will rise moderately.

FAQ About Collar Options Strategy

Why Is This Strategy Known as a Collar?

The collar options strategy is called as such because it involves “collaring” or limiting the range of possible outcomes for an investment. Just like a collar on a shirt keeps it in place, this strategy helps keep the investment potential profit or loss within a defined range.

How Can a Long Collar Strategy Help Protect You from Losses?

The put option that you need to buy as part of the strategy sets the floor at which you'll be able to sell your shares. That serves as your protection in case the stock falls further below that strike price.

Is Long Collar Options Strategy Bullish or Bearish?

A collar options strategy is generally neutral to bullish. It’s designed to protect against significant losses while allowing for some gains, which may be appropriate for investors who expect the stock price to remain relatively stable or move moderately. It’s not inherently bullish (expecting the stock to rise) or bearish (expecting the stock to fall), but rather a way to manage risk and assist in providing a more a balanced outcome. The strike prices selected will determine the level of protection it could provide and the cap on potential profit.

How a Protective Collar Options Strategy Works?

The long ollar options strategy can protect the investor through put options that may allow him or her to sell the stock at the predefined strike price, even if the stock price plunges below that level. At the same time, selling call options allows for him or her to offset some of the cost of buying the put options. But those call options also may limit the upside potential because its holder could end up exercising the contract. In that case, the investor who sold the call options would be required to sell the shares at the predefined strike price, even if the stock price rises above it.