Collar

A Collar (also known as a 'protective collar') is an options strategy designed to protect an investor's gains in a stock they already own. Think of it as building a 'fence' around your stock's price. You establish a price floor below which your investment can't fall, but in exchange, you also set a price ceiling above which your profits can't rise. This is achieved by simultaneously buying a put option (your insurance against a price drop) and selling a call option (which pays for the insurance but caps your upside). For an investor who has enjoyed a significant run-up in a stock but is nervous about a potential short-term pullback, a collar can be a low-cost way to sleep better at night. It effectively locks in a range of potential outcomes, protecting capital from a major downturn while sacrificing potential windfall profits.

At its core, a collar is a three-legged position you build around a stock you own (the underlying asset):

• Leg 1: Long Stock. You already own at least 100 shares of a company.
• Leg 2: Buy a Protective Put. You buy a put option, which gives you the right, but not the obligation, to sell your shares at a predetermined price (the strike price) before a certain date. This is your safety net, establishing the minimum price you will receive for your stock.
• Leg 3: Sell a Covered Call. You sell a call option, which gives the buyer the right to purchase your shares from you at a higher, predetermined strike price. The cash you receive for selling this option (the premium) helps pay for the put option you just bought. This is why it's a covered call—you own the underlying shares, so you're 'covered' if the buyer exercises their option.

The magic happens when the premium you receive from selling the call mostly or entirely covers the premium you paid for the put. When the costs are equal, it's called a zero-cost collar. You've essentially gotten downside protection for free, with the only “cost” being the limit on your future profits.

Let's say you bought 100 shares of a fictional company, “Value Vistas Inc.” (VVI), at $50 per share, and it has since soared to $100 per share. You're sitting on a nice $5,000 gain, but you think the market might get rocky. You don't want to sell and pay capital gains tax, but you also don't want to lose your hard-earned profit. You decide to put on a collar:

1. You buy one VVI put option with a strike price of $90, expiring in three months. This gives you the right to sell your 100 shares for $90 each, no matter what. Let's say this insurance costs you a premium of $2 per share, or $200 total (100 shares x $2).
2. You sell one VVI call option with a strike price of $110, expiring in the same three months. This obligates you to sell your shares for $110 if the buyer chooses. For taking on this obligation, you receive a premium of $2 per share, or $200 total (100 shares x $2).

In this scenario, you've created a zero-cost collar. Now let's see what happens when the options expire:

• Scenario A: VVI trades between $90 and $110. If VVI closes at, say, $105, both options expire worthless. Your put isn't needed, and the call buyer won't exercise their right to buy at $110. You keep your shares, and the transaction was a wash. You're exactly where you would have been, just with the peace of mind you had for three months.
• Scenario B: VVI plummets to $75. Disaster averted! Your put option is now very valuable. You can exercise it and sell your shares for $90 each, limiting your loss. Your 'price floor' held firm.
• Scenario C: VVI skyrockets to $125. This is the trade-off. The call option you sold will be exercised, and you'll be forced to sell your shares at the $110 strike price. You'll miss out on the extra gains from $110 to $125. Your 'price ceiling' has capped your profit.

A strict value investing purist might argue that if you've bought a wonderful business at a fair price, you should simply hold it through thick and thin, ignoring market fluctuations. However, a more pragmatic value investor might see a collar as a sensible risk-management tool in specific circumstances. It's not for speculation. Rather, a value investor might use a collar when:

• Protecting a Concentrated Position: You have a large, successful investment that now makes up a disproportionate amount of your portfolio. A collar can reduce the risk of this concentration without forcing an immediate sale.
• Managing Tax Consequences: You have a massive unrealized gain and want to defer paying taxes. A collar protects the gain while delaying the taxable event that a sale would trigger (unless your shares are called away).
• The Stock Nears Intrinsic Value: You've determined the company's intrinsic value is around $115. Setting a call strike at $110 means you're happy to sell at that price, as you believe further upside is limited anyway. It becomes a disciplined way to take profits.

While useful, collars are not without their downsides.

• Capped Upside: This is the big one. If the stock you've collared turns out to be the next big thing and triples in value, you'll only participate in a small fraction of that gain. This can lead to a serious case of investor regret.
• Transaction Costs: While you can aim for a zero-cost collar, brokerage commissions and the bid-ask spread on the options can add up.
• Dividend Risk: If your shares get called away just before the ex-dividend date, you will miss out on receiving that dividend payment.
• Complexity: Options are more complex than simply buying and holding stock. You need to understand strike prices, expiration dates, and the risks involved before attempting this strategy.