Investing
4 Reasons the Collar Strategy Suits Conservative Investors
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A collar strategy can be a useful tool for investors looking to protect their stocks from downside risks. While it offers a form of protection, it also limits potential profits. In this article, we’ll explore what a collar is, how it works, and its pros and cons.
What Is a Collar Strategy?
A collar, also called a hedge wrapper or risk-reversal, is an options strategy used to protect stocks from significant losses while capping potential gains. Investors typically use this strategy when they’re optimistic about a stock’s long-term prospects but worried about short-term volatility.
The collar involves two key options:
- Buying a put option(B): This protects the stock from price drops by setting a floor for potential losses.
- Selling a call option (A): This generates income to offset the cost of the put option, but it also caps the upside potential of the stock.
While a collar can safeguard against major losses, it also prevents profits from exceeding a certain level.How Does the Collar Strategy Work?The collar strategy is built on the combination of two options:
- Protective Put: This is like an insurance policy for your stock. If the stock drops in value, the put allows you to sell at a predetermined price, limiting losses.
- Covered Call: By selling a call option, you agree to sell your stock at a specified price. In return, you receive a premium, which helps cover the cost of the put option.
Example:
Let’s say you own stock XYZ, bought at $100 per share. To protect yourself from a potential drop, you:
- Buy a put option with a strike price of $95 (premium: $5).
- Sell a call option with a strike price of $105 (premium: $4).
Breakeven Point and Potential ProfitsThe breakeven point for a collar strategy is calculated by factoring in the cost and income from the options.
- Breakeven (Credit Collar): Stock price + Put premium – Call premium
In our example, that would be $100 + $5 – $4 = $101.
Maximum Profit:The most you can make is the difference between the call strike price and the stock purchase price, plus any premium received:
- $105 (call strike) – $100 (purchase price) + ($4-$5) (net premium) = $4.00 per share, or $400 for 100 shares.
Maximum Loss:The worst-case scenario is the stock price falling below the put strike price, adjusted for premiums:
- $95 (put strike) – $100 (purchase price) + $(-1) (net premium) = -$6.00 per share, or - $600 for 100 shares.
Pros and Cons of the Collar Strategy
Pros:
- Downside protection: The put option limits your losses.
- Some upside participation: You can still profit up to the call’s strike price.
- Low-cost: Often, the income from the call option can offset the cost of the put option, making the collar a cost-effective strategy.
Cons:
- Caps potential gains: If the stock price rises above the call strike, you’ll miss out on additional profits.
- Requires monitoring: The strategy needs active management, especially during volatile market conditions.
- Not ideal for very bullish investors: If you expect the stock to soar, a collar might not allow you to fully capitalise on that growth.
When Is the Best Time to Use a Collar?
Collars work best when you’ve already seen your stock appreciate in value and want to protect those gains from a potential downturn. It’s especially helpful if you're moderately bullish or neutral on the stock and don't want to risk losing significant value in a short-term market dip. This strategy is particularly effective in volatile markets where downside risks are high but you still want some upside potential.
Conclusion
A collar is a protective strategy that balances risk and reward. While it limits potential gains, it offers peace of mind by preventing major losses. If you’re holding a stock that’s appreciated in value but you’re unsure about near-term market movements, a collar could be a smart way to hedge your position. However, it’s important to understand that by limiting your upside, you’re essentially trading off potential gains for protection.
