Options 101: Collar Your Portfolio
Limiting downside losses, insuring your investment.
It's time to take a quick look at another basic option strategy. This is for both rookies and conservative investors.
Collars allow you to own stocks -- even during a bear market and its anxieties -- because they establish a floor for the value of your holdings. In other words, you know in advance how much you can lose in a worst-case scenario. Collars are flexible, and you can be certain that losses don't exceed any level you choose. As with any insurance policy, if you want that loss (the deductible) to be very small, the cost (premium) is higher.
What is a collar?
A collar is a position consisting of 3 parts:
- Short call option
- Long put option
Collars are designed to minimize the cost of buying insurance (the put option) by writing a covered call, collecting a cash premium, and using that premium to purchase an insurance policy. The insurance limits downside losses, and the covered call limits your upside potential. This is the ideal, conservative strategy for investors whose primary investment concern is the preservation of capital, and for whom earning profits is secondary, because this strategy allows you to do both.
To construct a collar: Buy stock, write a covered call option, and buy one put option. Typically, both the call and put options are out of the money. Because you own the put, if the value of your stock ever drops below the put strike price, you have the right to sell that stock -- at the strike price -- establishing a guaranteed minimum value for your investment. You may choose any strike price, but as the strike price moves higher (allowing you to sell stock at a higher price), you must pay more for the put.
To offset all or part of the cost of buying the put, a call option is sold. As with covered call writing, choose a call option that suits your needs. You may prefer to sell an option that's at the money, sacrificing upside potential in return for collecting a higher premium. You may decide to sell an out-of-the-money option, collecting less cash, but giving yourself the chance for an upside profit.
There is no "best" collar, and investors must find appropriate options to build a collar position that allows them to achieve their investment objectives. The trade must also fall within the investor's comfort zone.
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