One of the primary benefits of options is the ability to "insure" against losses in your stock trades. With puts, a stock buyer can protect against a downside stock move on a point-for-point basis, explains Bernie Schaeffer, editor of the industry-leading Option Advisor.
This protection can kick in immediately if you purchase an at-the-money put (the intrinsic value of the put will exactly compensate for the loss in the stock).
This "insurance" can also be structured to kick in after the stock suffers a minor loss, if you're buying an out-of-the-money option. But put premiums can be expensive, especially in a volatile market. So, how do you reduce your cost but still maintain the same level of desired protection?
Let's say you've owned 100 shares of stock XYZ for a couple of months and it's gained some ground. You now want to protect those gains with a put option, but don't want to pay the full price. At the same time, you'd be willing to sell the stock above its current price.
This is an ideal situation for a collar -- a strategy that involves the purchase of a put option and the sale of a call option on the same pre-owned underlying stock (the call is always at a higher strike than the put).
In essence, the collar trader uses the proceeds from the sale of the call to wholly or partially finance the purchase of the put. However, this low-cost insurance does not come for free. In this particular strategy, the cost is that you're capping the profit potential on your stock holding at the strike price of the written call.
For example, assume you're nervous about the downside potential of XYZ and want some protection. The stock is trading at $76, and though it has declined during the past week, you remain bullish, believing it may recover and advance about 5% before June expiration.
You establish a collar by selling one XYZ June 80 call and buying one XYZ June 70 put. You are able to sell the 80 call at $3 and buy the 70 put at $3, thus creating a net cost of zero.
Remember, the goal of a collar is to insure your investment at little to no cost. Thus, the sale of the call subsidizes the protection offered by the put purchase.
Let's now see how this position plays out at option expiration. With the stock between $70 and $80, both options are out of the money and will expire worthless.
Thus, the position's value is dictated solely by the price of the stock, and will range from a loss of $6 (with the stock at $70) to a gain of $4 (with the stock at $80). You retain ownership of the stock and can either hold, sell, or hedge again with another collar.
Below a stock price of $70, the purchased put will increase in value, negating any further downside in the stock. In other words, the loss (akin to the deductible of an insurance policy) is limited to $6 because of the put.
At a stock price above $80, the written call will gain in value as it goes deeper in the money. The increasing liability for this call will exactly counteract the increase in the stock price. Thus, the net effect of the written call is to cap the maximum gain at $4 for all stock prices at or above $80.
The bottom line for this collar is that you have gained a measure of downside protection below a stock price of $70. The cost for this protection is that your maximum gain on the stock is capped at $80.
At a stock price above $80, the written call will gain in value as it goes deeper in the money. The increasing liability for this call will exactly counteract the increase in the stock price. Thus, the net effect of the written call is to cap the maximum gain at $4 for all stock prices at or above $80.
The bottom line for this collar is that you have gained a measure of downside protection below a stock price of $70. The cost for this protection is that your maximum gain on the stock is capped at $80.
