A collar is an options strategy in which the stock is purchased or acquire. Or followed by the purchase of a put option at strike price A and the sale of a call option at strike price B. When using this method, an options trader hopes that the stock will trend higher. Also, be called away at the call strike price B. However, they also want to be covered in the event that the stock price drops below strike price A. allowing them to sell the stock and execute their option if that happens.
In essence, a collar option is what would occur if a trader wanted to simultaneously run a covered call and a protected put. When an investor wants downside protection but does not willing to pay for it. they typically use this method. They therefore cap their exposure to the downside in return for limiting their upside potential in order to meet their costs. Both short-term and long-term positions can use this tactic.
When to Use a Collar
If an investor is positive on the stock over the long term but is worried about short-term downward volatility. They should think considering utilizing a collar. A pandemic, unclear profitability, or any other short-term market. Uncertainty are a few examples of such things.
When a stock has made large gains that the investor doesn’t want to risk losing. They may also utilise a collar. In this situation, an investor can use a collar option strategy to safeguard their prior gains.
The investor buys an out-of-the-money put option that guards against a decline.Also, in stock price in order to apply the collar.
In a turbulent market, the collar is a very helpful technique since it protects the investor for little to no money. Allowing them to limit their possible loss if the stock moves lower while restricting their potential profit. The call option is sold above the stock price. Which allows the investor to still make a profit while allaying their concerns about the stock falling in value.
Profit/Loss
The difference between the stock price and the short call is used to determine the maximum profit, from which the cost of the collar (if it was purchased with borrowed money) is subtracted or the premium earned (if the position was opened with credit) is added. The maximum profit, in this case, would be Rs 5.30 if the stock was trading at Rs 100 and the trader bought a 95/105 collar for a Rs 0.30 credit.
The maximum loss is determined by removing the premium earned if the long put was opened for a credit. Adding the collar cost to the difference between the stock price and the long put. The maximum loss. For instance, would be Rs 4.70 if the stock was trading at Rs 100 and the purchaser purchased a 95/105 collar for a Rs 0.30 credit.
Breakeven
The breakeven point for the collar option is the same. But it is determined differently depending on whether the collar was purchased for a credit or a debit.
When buying a collar on credit, the breakeven point is determined by deducting the premium from the stock price.
If the collar is purchased on credit, the breakeven point would be determined by multiplying the purchase price by the stock price.
Example
A trader might execute a 95/105 collar by purchasing the stock. So, purchasing one put at the strike price of 95. Selling one call at the strike price of 105 for the following prices. If XYZ is trading at Rs 100 and is anticipated to trade lower during the following three months.
- 100 shares of XYZ stock are purchased for Rs 100.
- For Rs 1.50, purchase 1 XYZ 95-strike price put.
- 1 XYZ 105-strike price call being sold for Rs 1.80.
- The total premium is equal to Rs 0.30.
The call will be exercised and the investor will be required to sell the XYZ stock in their inventory for Rs 105. If the stock trades up to Rs 107 at expiration. As a result, they will earn a Rs 0.30 credit in addition to a Rs 5.00 profit on the stock, for a total gain of Rs 5.30.
The trader will execute the 95-strike price put and sell the stock at Rs 95 if the stock trades lower than Rs 91 at expiration. This would indicate that they suffered a loss of Rs 5.00 on the stock. But since they were able to sell the collar for a credit of Rs 0.30. Their actual loss was only Rs 4.70. Losses are never desirable. But in this case, having the collar on would be far better than if they had to bear the entire Rs 9.00 loss.
Conclusion
There is just one justification for entering a collar. To keep downside risk to a minimum while leaving room for upside possibilities. Option strategies of this kind might be purchased concurrently with stock purchases or added to existing stock positions. The fact that the trader is aware of the trade’s maximum gains and losses as soon as they enter the collar is one of its strongest features. Here, the trader limits their losses in exchange for the chance for large rewards.
Since it is long one option and short another, balancing the volatility effect. It is only very little sensitive to fluctuations in implied volatility.
The collar is a great trading technique for a newbie. Since it enables the trader to profit from price increases while keeping them relatively secure. In case their bullish forecast is incorrect.
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