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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • The Collar - Expanding The Butterfly 1 comment
    May 11, 2013 9:10 AM

    A collar is a complex option strategy with three parts: Ownership of 100 shares of the underlying stock, a long put, and a covered call. The combination of the two options creates a low-cost or cost-free position, because the short call premium pays for all or most of the put. Both options are out of the money, meaning the call strike is higher than current value of the stock, and the put strike is lower. The options also expire in the same month.

    What does this position achieve? It is a defensive position, intended to protect profits if the stock price declines. However, if the stock price rises, the stock may be called away, thus doing away with potential for greater profits. So a collar is best opened when the stock has appreciated and the strike on the call will create a capital gain in the stock. Traders who employ collars expect the stock value to decline. However, they do not want to sell for several reasons. First, it will create a tax liability this year. Second, the no-cost or low-cost collar protects profits if the stock's price does fall. Third, even if the stock price rises, the short call can be rolled forward or closed to avoid exercise.

    So the collar provides cost-free downside protection in exchange for possibly limiting upside profits. However, since stock has appreciated by the time the collar is opened, exercise would still create profits from the stock capital gain as well as any net option premium (if the collar creates a net credit between short call and long put).

    A collar will not make sense if the stock value has declined since purchase. If exercise of the short put would create a net capital loss, it makes no sense to set up a losing position. The shortfall may be recovered with a well-selected covered call, but if not it is best to either wait for the stock price to rise, or simply sell shares and take the loss in the current tax year.

    It makes sense before opening the collar to calculate a breakeven point from the position. The short call's strike must be greater than the net basis in stock. On the downside, the protection is equal to the strike of the put, plus or minus the net cost/receipt of the two options. In cases where a long put is used by itself, the downside protection is equal to the strike of the put minus the cost of the put. However, that put cost has to be reduced by the short call premium received.

    The position can be converted to an insurance put if and when the time decay of the call makes it worthwhile to close the short position. In this case, the net cost (original cost of both options plus cost to close the call) creates the adjusted downside breakeven point.

    In other words, before entering into any multi-option strategy, evaluate not only the best-case outcome, but the potential worst-case as well.

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

    I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

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  • Windwood Trader
    , contributor
    Comments (2443) | Send Message
     
    Michael-

     

    Thanks for a very succinct article on collars. Since I own some TSLA purchased a while back (30s) I would like to preserve my gains and possibly expand those gains with a collar strategy.

     

    Your thoughts would be appreciated.

     

    Thank you-

     

    Windwood Trader
    11 May 2013, 05:56 PM Reply Like
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