Collar Option Spread
The collar option spread strategy is a trading strategy that is constructed by being long shares of an underlying stock or equity while simultaneously selling call options and buying protective puts against the underlying. Both the calls and puts are out of the money options having the same expiration month. They must be equal in the number of contracts (bought and sold).
The collar strategy is generally used when the option trader is writing covered calls to collect premium but wishes to protect himself from any unexpected sharp turns to the downside of the underlying security. Essentially you’re using a little bit of the premium collected to pay for your downside protection.
Collar Option Spread Risk Profile
Composition
Long the underlying security
Long OTM Put Option
Short OTM Call Option
1:1:1 ratio
Risk/Reward
Max Reward: Limited to the difference between two strikes plus any premium paid/received for options bought/sold, plus any gain from the the stock position.
Max Risk: Limited to the difference between two strikes less any premium paid/received for options bought/sold, less any loss the the stock position.
If the net premium is a credit, i.e. you received money for the option positions, your maximum gain will be the difference between the strikes plus this amount (and then plus the profit from the stock position). If the net premium was a payment (debit) then it is subtracted from the strike differential.
Characteristics
You can see from the risk profile above that the collar looks and behaves exactly like the long call spread strategy.
The collar is maximum protection strategy and for the most part the collar is purely defensive in nature. We’re trying to provide maximum protection for the long stock position.
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