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Protective Collars And When To Use Them

The problem for anyone in the market is the threat of loss. Owning stock means you risk a decline in the price, and this is where some specific options-based protective strategies are exceptionally valuable. One such strategy is the collar.

The collar has three parts: 100 shares of stock, a short call, and a long put. If the stock price rises, the call is exercised and the stock is called away. As long as the strike is higher than your basis in the stock, your profit comes from the option premium plus capital gains on the stock. However, exercise can also be avoided by closing the call or rolling it forward.

If the stock price declines, the short call will expire worthless or can be closed at a profit. The long put will grow in value point for point with decline in the stock once the put is in the money. This strategy limits profit while putting a ceiling on losses. So while it is not going to create large profits, it does protect you.

The collar often is entered in stages, not all at once. For example, your stock rises and you sell a covered call. However, the stock then begins to decline. Rather than close the call and sell the stock, you open a long put to protect against the decline, should it continue.

The strikes of the typical collar are both out of the money. For example, a company's stock was worth $89.26. At that point in the trading day, you could create a collar with a June 90 call (sold for 1.25) and a June 87.50 put (costing you 1.57). The net cost of this collar is $22 plus trading fees. So for under $40 overall, you build in downside protection; and as long as you bought 1200 shares of the stock for under $87.50 (the put's strike), exercise of the call creates a net capital gain.

If your concern is that the stock price could slide downward, the collar is a sensible strategy that also helps you avoid selling, if that is the only alternative. This is an example of how options can be used to manage your portfolio, reduce risk, and minimize the cost of the strategy itself. In this example, the pre-trading fee cost is only $22.

Another example, one somewhat more expensive for a stock priced in the same range, is that of a company's stock worth $88.32. A collar could be created with a July 90 call, which yields you 1.73; and a July 87.50 put, which costs you 2.36. So your pre-trading fee cost for the collar is $63. This is not bad considering that you get downside protection below $87.50. Here again, you might have purchased stock at a lower price and sold a covered call, and now want to protect against the possibility of a price decline. Transforming a covered call into a collar makes sense in this situation.

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