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.
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