Collar Strategy

A collar strategy is a multi-leg options strategy that combines a long stock position, an out-of-the-money covered call, and an out-of-the-money protective put. The collar creates a risk-defined position with limited profit potential.
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A collar strategy is a multi-leg options strategy combining a covered call and protective put. Selling the covered call will result in a credit that can be used to offset the cost of purchasing the protective put.

Collar Outlook

Collar strategies are used by investors who hold long stock and want defined risk. The goal of the collar strategy is to fund the cost of the long put with the credit from the short call. A collar strategy combines the downside protection of a protective put with the earning potential of a covered call. The strategy can be entered for a credit, debit, or cost-free, depending on the width of the collar’s strike prices.

Collar Setup

The collar strategy requires owning or purchasing at least 100 shares of stock and combining the position with a covered call above the stock price and a protective put below the stock price. The compromise of limiting the upside profit potential is offset by the downside risk protection. The put and call options can be set up at any expiration date and strike price the investor chooses, but the call and put sides of the collar must have the same expiration date and number of contracts.

The further from expiration the position is entered, the more money will be collected on the short call option, and the more expensive the cost of the long put option. Similarly, the closer the options are to the stock price, the more money will be collected on the call and paid for the put.

Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Investors typically try to enter a collar at no cost or for a credit, but a small debit is sometimes paid. Because of the put-call parity in options pricing, a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. Therefore, if an investor wishes to enter a costless position, they would generally need to have a slight skew in strike prices relative to the underlying stock, where the strike price of the call option is closer to the underlying stock than the strike price of the put option.

For example, a collar on a stock currently trading at $100 may be entered for a debit with a $105 call option and $95 put option, a credit with a $104 call option and $95 put option, or costless with a $105 call option and $94 put option.

Collar Payoff Diagram

The collar strategy payoff diagram has a defined maximum profit and loss. Shares of the underlying asset may be sold at the short call strike price or the long put strike price if the option is in-the-money at expiration. If the stock is between the two levels at expiration, both the call and put options will expire worthless. The credit received for selling the call will remain but will be offset by the price of buying the put.

Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Calls sold closer to the stock price will receive more credit and puts purchased closer to the stock price will be more expensive. Investors typically try to enter a collar at no cost or for a credit.

For example, an investor may choose to enter a collar position for a stock that was purchased for $100. A $105 call may be sold and a $95 put may be purchased. If the position had a debit of $1.00 at entry, the cost basis of the long stock position will increase by $1.00 to $101. The collar will limit the profit potential above $105, but the long stock will be protected from any price movement below $95. The maximum loss would be -$600 if the stock is below $95 at expiration ($100 - $5 - $1 debit), and the maximum profit would be $400 if the stock is above $105 at expiration ($100 + $5 - $1 debit).

Image of a collar payoff diagram showing max profit, max loss, and break-even points

Entering a Collar

A collar is built around stock ownership. The stock position can be owned before entering the covered call or purchased simultaneously with the short call and long put. The collar is essentially a covered call position combined with a protective put. To initiate the collar strategy, a call is sold above the stock price and a put is purchased below the stock price. Both options will have the same amount of contracts and expiration dates. Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Calls sold closer to the stock price will receive more credit, and puts purchased closer to the stock price will be more expensive. Investors typically try to enter a collar for no cost or for a credit, but a small debit is sometimes paid.

For example, an investor may choose to enter a collar position for a stock that was purchased for $100. A $105 call may be sold, and a $95 put may be purchased. Because of the put-call parity in options pricing, a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. Therefore, if an investor wishes to enter a costless position, they would generally need to have a slight skew in strike prices relative to the underlying stock where the call option’s strike price is closer than the strike price of the put option.

Exiting a Collar

The collar is exited if either the short call or long put is in-the-money at expiration. In this case, the options contract will be exercised, and the stock will be sold at the corresponding strike price. If neither option is in-the-money, both contracts will expire worthless, and the investor may choose to initiate a new collar strategy for a later expiration date.

Time Decay Impact on a Collar

Time decay will impact the long and short options differently in a collar strategy. Short option positions benefit from time decay, or Theta, while long options are negatively affected. However, with a collar strategy, the protective put is in place to control downside risk, not to generate profit. Ideally, it expires worthless. The short call option will decline in value as time progresses.

Implied Volatility Impact on a Collar

Implied volatility will impact the price of options premium when the collar strategy is entered. The higher the level of implied volatility, the more the options will cost. This will benefit the pricing of the short call contract but have a negative impact on the pricing of the long put contract. Because collar options are typically only exercised if they are in-the-money at expiration, implied volatility changes should not affect the strategy while in the trade.

Adjusting a Collar

Collar strategies can be adjusted during the trade if the investor chooses to not exercise the options at expiration. If he or she chooses to extend the trade because they are not ready to close out the long stock position, then the challenged options contracts can be adjusted up or down, or rolled out to a later expiration date. If the long put option is being challenged, the short call can be adjusted down by buying back the original call option and selling a new contract closer to the stock price.

For example, if a collar was entered with a $105 call and a $95 put, and the stock price has moved lower, the $105 call option may be purchased and a $100 strike call option may be sold. This will bring in more credit and lower the overall cost of the position. If the stock has moved down and the investor believes it will rally in the future or if the stock has moved up and the investor believes it will continue to climb, the collar can be rolled out to a later expiration.

Rolling a Collar

Rolling a collar position can extend the duration of the trade. Suppose an investor chooses to stay in the trade, as opposed to exercising their options contracts. In that case, he or she can exit the current position by buying-to-close (BTC) the covered call and selling-to-close (STC) the protective put and opening a new position for a later expiration date. The new collar position can be at the same strike prices, or they can be adjusted up or down to reflect the new stock price.

Hedging a Collar

Collars are typically not hedged because the strategy itself is in place to protect against downside risk in a long stock position. The protective put will act as security if the stock position declines in price, thereby creating a hedge against the initial bullish bias of owning the long stock position.

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