Collar strategy for options
A collar strategy aims to reduce the premium paid for insurance of stocks (read about insurance for stock, click here) to very low while keeping the opportunity for limited profits.
Collar strategy in technical terms, we will follow it up with a no jargon explanation:
A collar strategy is selling a call and buying a put on an underlying asset to protect value while paying/recieveing a small amount.
Read the investopedia definition.
That is way too complicated for me. I understand this simply as:
If you own a house and want to protect your investment you can buy house insurance. As with all insurance you need to pay a premium. Detailed explanation: click here
At the same time, you can also earn rent from your house. Detailed explanation: click here
Earning rent from the house is a strategy where we agree to give our shares to a buyer at an agreed price(Strike Price) till a certain date(expiry date). If on the agreed date the share price is higher than the agreed price.
The buyer give us a rent(premium) to have the opportunity of owning the stock at the agreed price if price goes above the agreed price on the agreed date.
If you take rent and pay insurance premium, then there is a chance that the premium can be paid partially or fully by the rent. The appreciation in house value will go to you but partially.
Substitute stock/share in the statements above and that is a collar strategy.
The insurance is called buying a PUT option.
The rent is called writing/selling a CALL option.
You are not allowed to rent or insure a room in the house. You can only insure or rent the entire house. The house in case of stocks is called a lot. Which is a set number of shares that can be either insured or rented.
Lets take a look at what can happen over a few months:
Month 1:
Investment:
Opening stock price/Purchase price: 1,000
Lot: 200 Shares
Invested Amount: 1,000 x 200 = 200,000
Insurance:(Buy Put)
Strike/Insured Price: 800
(If price of share is below 800 at the end of the month we will get (800 – end of month share price) * lot)
Amount Invested: 1,000 x 200 = 200,000
Insured amount: 80% of stock value i.e. 1,000 x 200 x 80/100 = 160,000
Insurance premium paid: 1% i.e. 1,000 x 200 x 1/100 = 2000
Our insurance expires at the end of the month.
Rent:(Sell Call aka Write Call)
Agreed price(Strike Price): 1100
This is the price at which the person paying rent will buy the shares, if price at the end of the month is above 1100.
Rent received: 2% of stock value i.e. 1,000 x 200 x 2/100 = 4000
We keep the rent and shares if price is below 1100 at end of the month.
What happens at the end of the month:
| Stock Price: (month opening) |
Insured Value | Premium Paid | Rent Received | Renter Buys Above: | Closing Stock Price | Profit/Loss | Investment Value |
|---|---|---|---|---|---|---|---|
| 1,000 | 160,000 | 2,000 | 4,000 | 1100 | 1000 | +2,000 | 200,000 |
| Price of stock at the beginning of the month | Price x Quantity x 80/100 = 16000
80% of stock value is insured. |
1% is the insurance premium.
Price x Quantity x 1/100 = 2000 |
Rent received | If Closing price is above this, the rentor buys the shares for 110 each. | Stock price at end of the month. |
The insurance premium is kept by the insurance company. It will be considered a loss. The price is less than 1100, the person paying us rent tells us to keep the rent. Rent Received – Insurnce Paid = 4,000 – 2,000 = +2,000 |
Investment value remains the same as purchase price and current price is the same. |
| Stock Price: (month opening) |
Insured Value | Premium Paid | Rent Received | Renter Buys Above: | Closing Stock Price | Profit/Loss | Investment Value |
|---|---|---|---|---|---|---|---|
| 1000 | 160,000 | 2,000 | 4,000 | 1100 | 1050 | +2,000 | 210,000 |
| Price of stock at the beginning of the month | Price x Quantity x 80/100 = 160,000
80% of stock value is insured. |
1% is the insurance premium.
Price x Quantity x 1/100 = 2000 |
Rent received | If Closing price is above this, the rentor buys the shares for 1100 each. | Stock price at end of the month. |
The insurance premium is kept by the insurance company. It will be considered a loss. The price is less than 110, the person paying us rent tells us to keep the rent. Rent Received – Insurnce Paid = 4,000 – 2,000 = +2,000 |
Investment value increased by 50 per share as the current price is higher than purchase price. |
| Stock Price: (month opening) |
Insured Value | Premium Paid | Rent Received | Renter Buys Above: | Closing Stock Price | Profit/Loss | Total Profit/Loss |
|---|---|---|---|---|---|---|---|
| 1050 | 160,000 | 2,000 | 5,000 | 110 | 140 | +3,000 | +5000 |
| Price of stock at the beginning of the month | Price x Quantity x 80/100 = 16000
80% of stock value is insured. |
Insurance Premium paid | Rent received | If Closing price is above this, the rentor buys the shares for 1100 each. | Stock price at end of the month. |
The insurance premium is kept by the insurance company. It will be considered a loss. The price is greater than 1100, the person paying us rent will take the stock at 1100 per share. Rent Received – Insurnce Paid = 5,000 – 2,000 = +3,000 |
Investment value increased by 400 per share as the current price is higher than purchase price. The person paying rent has bought the share at 110 from us, so we will recieve only 1100 as our selling price. (Sell to Renter price – Purchase Price) x Quantity + (Rent – Insurance premium) = (1,100 – 1,000) x 200 + (5,000 – 2,000) = +23,0000 |
| Stock Price: (month opening) |
Insured Value | Premium Paid | Rent Received | Renter Buys Above: | Closing Stock Price | Profit/Loss | Investment Value |
|---|---|---|---|---|---|---|---|
| 1400 | 200,000 | 2,000 | 5,000 | 1500 | 500 | +3,000 | 160,000 |
| Price of stock at the beginning of the month | Opening Price x Quantity x 80/100 = 200,000
100% of stock purchase value is insured. |
1% is the insurance premium.
Purchase Price x Quantity x 1/100 = 2800 |
Rent received | If Closing price is above this, the rentor buys the shares for 1500 each. | Stock price at end of the month. |
The insurance premium is kept by the insurance company. It will be considered a loss. The price is less than 1500, the person paying us rent tells us to keep the rent. Rent Received – Insurnce Paid = 5,000 – 2,000 = +3,000 |
Investment is below our insured amount, the insurance company will pay us the difference: Insured Amount – Current Value = 160,000 – 100,000 = +60,000 Our investment value will be: 160,000 after receiving the insurance money. |
What happens if we didn’t have insurance and rent?
(Current Price – Purchase Price) x number of shares = (5,00 – 1,000) x 200 = -100,000 that is a 50% loss
Even though our investment pick was wrong we are still in a much better position with the collar strategy. If the case 1, 2 had been true for even 2-3 months before the loss in case 4, we would be net positive.
Note: chances of getting trades such as the ones used in the example are low/non-existent. We merely want to get clear on the concept. Practical guide is coming soon, drop us your email and we will update you.
Insuring your stocks is a good practice. Concept explanation click here
What are futures and options? Concept explanation click here
Covered Calls explanation using a house. Concept explanation click here
All information here is for educational/research purposes only, we do not recommend trading.