What is a Collar option Strategy? When to use it?

Short Answer

A collar option strategy is a multi-leg option strategy that involves an existing long position in any security in the Equity or Futures market and buying an OTM (Out Of the Money) Put option and selling an OTM Call option in order to hedge the existing long position from any short term bearishness. The overall Profit and loss are capped in this strategy and this strategy is implemented when the overall outlook of the underlying asset is bearish.

Detailed Answer

Collar Option Strategy-

A collar strategy can be called a hybrid strategy as it involves taking a position both in the Cash as well as the Futures & options market. In a collar strategy, an investor/trader goes Long (Buys) an Asset from the cash or Futures market and buys an OTM (Out Of The Money) Put option as well as sells an OTM Call option.

In this way the downside of the particular asset is limited as if the price of the asset falls, the Put premiums will increase as well as the premiums of Sold call options will also decrease writing off the loss faced of the underlying asset.

When to use it-

A collar strategy is used as a hedge for long-term positions. When the long-term view of an asset is bullish but to protect it from the immediate downside, a Collar strategy is used. It can be used when a trader/Investor already has a long position in any particular asset which he wants to hedge and the outlook for that particular asset is bearish.

To implement a Collar strategy the following options have to be executed-

Existing Long position in ‘X’

  • Buy 1 OTM (Out of The Money) Put option.
  • Sell 1 OTM (Out of The Money) Call option.

In this way, a Collar strategy is implemented. A Zero Cost Collar can also be implemented, when the Net credit received from Selling the Call Option is used to buy an OTM Put option. In this way, no additional premium is paid for this strategy other than the span margin.

Let’s see how a collar strategy works-

Let's assume I already have a long position in Infosys for the long-term. The price has already increased by 10% but I don’t have any intention to sell the stock to realize those gains but I intend to protect those gains as the overall outlook for the stock appears to be bearish in the short term. In this case, I can implement a Collar strategy buy the following steps-

  • Sell 1 OTM Call option of Infosys.
  • Buy 1 OTM Put option of Infosys.

Now if the price of Infosys drops, I will face some losses in the existing long positions buy the Premium of the Put option will increase as well as the premium of the Call option will decrease. This will offset the losses faced in the Stock in my holding.

This is the payoff graph after implementing this Collar strategy on Infosys.

infy collar...png

As seen above the profit and losses are capped till this strategy is in implementation hence even if the stock falls by a substantial margin then also there will be a limited loss and vice-versa.

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Categories: Option Trading
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