April 01, 2025
9 mins read
A collar options strategy is a popular hedging technique investors use to protect gains or limit potential losses in an existing stock position. It involves three key components: holding the underlying stock, buying a protective put option, and selling a covered call option. This strategy aims to create a risk-management approach that limits downside risk while capping potential upside.
In a collar options strategy, the investor buys a put option to secure the right to sell the stock at a specific price (strike price), thus providing a safety net against a significant decline in the stock's value. Simultaneously, the investor sells a call option on the same stock, which generates premium income. The premium received from selling the call helps offset the cost of purchasing the protective put.
Let's look at a simple example to help us comprehend the collar options strategy.
Let's say you hold 100 shares of ABC stock, which costs ₹80 a share. You don't want to sell the stock yet, but you're scared that the price might go down.
This is what you should do:
You buy a put option with a strike price of ₹75. You can sell your shares for ₹75 no matter how low the market goes. Let's say this costs ₹3 for each share.
You sell a call option with a strike price of ₹85. You have to sell your shares for that amount if the stock goes above ₹85. When you sell this call, let’s assume you make ₹2 for each share.
Net Cost: The cost of the put option is ₹3 times 100, which is ₹300.
Income from the call option is ₹2 x 100 = ₹200.
The whole cost is ₹100.
What Could Happen?
Stock price between ₹75 and ₹85: Both choices run out. You keep your stocks.
If the stock price drops below ₹75, you can use your put option to sell at ₹75. Loss is not that big.
If the stock price goes over ₹85, the call is exercised. You sell shares for ₹85. There is a limit on profit.
This technique keeps your losses and gains to a minimum, which gives you peace of mind in markets that are hard to predict.
This is how you may quickly put up this plan:
Choose a stock that you already own or want to buy.
Choose a strike price that is higher than the stock's current price.
Choose a strike price that is lower than the stock's current price.
Find out if the premium from the call & Pull option helps pay for the put.
Keep an eye on the price of the stock. Change the plan if you need to.
If the stock stays between the strike prices, both options end and you keep the shares.
If the stock goes up, you can sell your shares at the call price.
If the stock price goes down, you can sell using the put option.
Let's quickly go over the good and bad points.
1. Controls losses
If the stock goes down, the put option gives you a safety net.
2. Less Expensive
Selling the call makes money that can be used to pay for the put.
3. Good for people who want to hold on to it for a long time
You can keep the shares and protect your investment at the same time.
4. Peace of Mind
You don't have to worry about every move in the market. Your risk is under control.
1. Profit is limited
You won't gain anything from a large rise above the call's strike price.
2. Needs to be watched
To make changes, you'll need to keep an eye on prices and expiration dates.
3. Not Right for All Markets
The method could not operate as planned if the market is either quiet or too erratic.
Here's another easy example.
You have 100 shares of a stock that is trading at ₹60.
Sell a Call: The strike price is ₹65. The premium you got was ₹2 per share, or ₹200.
Get a Put: The price to strike is ₹55. Price: ₹1.5 per share, or ₹150.
Net Credit: ₹50
Possible Outcomes: If the stock is worth more than ₹65, the shares are sold for ₹65. You make a profit.
If the stock is below ₹55, you sell it for ₹55 using the put. Loss is little.
Stock between ₹55 and ₹65: Both options end. You keep the ₹50 and the stock.
This is how the collar options trading method lets you make money while keeping your capital safe.
This plan works when:
Market is uncertain: You know things will change, but you don't want to leave your position.
You want to lock in your profits: Your stock has gone up, and you want to keep those gains safe.
You need risk control: You want to prevent yourself from losing money, even if it means not making as much money.
You want extra money: The call option gives you extra premium revenue.
You have a neutral view: You don't think either side will make huge moves.
The collar options approach is great for those who wish to protect their investments without selling them. By pairing a protected put with a covered call, you may set a clear risk-reward range. You lose some potential gains, but you gain protection, which is a good trade-off in unpredictable times.
A collar approach can be a clever tool for traders, whether they are long-term investors or only worried about short-term moves.
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A collar options strategy is a risk-management approach where an investor holds stock, buys a protective put, and sells a covered call to limit downside risk while capping upside potential
The protective put allows the investor to sell the stock at a predetermined price, ensuring losses don’t exceed a certain level, while the covered call offsets costs, reducing overall hedging expenses.
Yes, but profits are capped. Gains are limited to the call option’s strike price, minus premiums, while downside risks are mitigated by the put option, creating a defined risk-reward range.
The primary risks include capped profits, potential early assignment of the call, and costs associated with buying the put, which can reduce net returns if the stock remains stable.
Investors should use a collar when they want downside protection, have profits to secure, expect market volatility, or wish to hedge risk while maintaining stock ownership without immediate liquidation.
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