What is a Collar?
A Collar is an options strategy where you own a stock and want to protect against downside risk while also limiting your upside. It involves:
- Owning the stock (long stock position).
- Buying a put option to protect against a price decrease (downside protection).
- Selling a call option to cap the upside and generate premium income.
How Payoff Works:
If the stock price falls, the protective put limits your losses. If the stock price rises, your profit is capped by the call option you sold.
Example Payoff Scenarios:
- Initial Investment: $10,000 (buying 100 shares at $100 each).
- Premiums: You pay $2 per share for the put (total $200) and receive $1 per share for the call (total $100), so the net premium cost is $100.
- Stock Price = $85:
- You exercise your put option and sell the stock at $90.
- Stock Sale Value: 100 shares × $90 = $9,000.
- Payoff: $9,000 (stock sale) - $10,000 (initial investment) - $100 (net premium) = -$1,100.
- Stock Price = $100:
- Neither the put nor the call options are exercised.
- Stock Value: 100 shares × $100 = $10,000.
- Payoff: $10,000 (stock value) - $10,000 (initial investment) - $100 (net premium) = -$100.
- Stock Price = $120:
- You must sell your stock at the call strike price of $110 due to the call option you sold.
- Stock Sale Value: 100 shares × $110 = $11,000.
- Payoff: $11,000 (stock sale) - $10,000 (initial investment) - $100 (net premium) = $900.