Collars

A Collar (also known as a 'protective collar') is an options trading strategy used by investors to protect a large, unrealized gain in a specific stock. Think of it as putting a fence around your profits. This strategy sets a floor below which your investment's value won't fall, but it also sets a ceiling above which it won't rise. It’s a classic trade-off: you give up some potential future upside in exchange for downside protection. A collar is constructed by simultaneously holding the underlying asset (the stock you want to protect), buying a protective put option, and selling a call option. The goal is often to create a “costless collar,” where the income received from selling the call option completely covers the cost of buying the put option, making the insurance, in effect, free. This makes it a popular strategy for investors who are nervous about short-term market drops but don't want to sell their shares and trigger a tax bill.

A collar is a three-legged stool. If any one of the legs is missing, the whole thing topples over. The three legs are:

• The Stock You Own: You must already own the shares you want to protect. This isn't a strategy for speculating on a stock you don't have.
• The Protective Put (The Floor): You buy a put option. This gives you the right, but not the obligation, to sell your stock at a predetermined price, known as the strike price, before a certain date. This acts as your insurance policy, establishing the minimum price you can sell your shares for, no matter how far the market drops.
• The Covered Call (The Ceiling): You sell a call option. This generates income, called a premium, which helps pay for your protective put. By selling this call, you are giving someone else the right to buy your shares from you at a specific strike price. This action “caps” your potential profit, as you'll be forced to sell if the stock price soars past the call's strike price.

The magic happens when you structure the trade so that the premium you receive from selling the call is equal to, or very close to, the premium you pay for buying the put. This is what creates the famous costless collar.

Imagine you bought 100 shares of a tech company, “Innovate Corp,” years ago at $20 per share. The stock has had a phenomenal run and is now trading at $100 per share. You're sitting on a nice $8,000 profit! You still believe in the company long-term, but you're worried about a potential market correction in the next few months. You don't want to sell and pay capital gains tax, but you also don't want to see your hard-won gains evaporate. Here's how you could build a collar:

1. Step 1: Buy a Protective Put. You look at the options market and buy one put contract (representing 100 shares) with a strike price of $90 that expires in three months. This guarantees you can sell your shares for at least $90 each during that period. Let's say this insurance costs you $200.
2. Step 2: Sell a Covered Call. To pay for the put, you sell one call contract with a strike price of $115 that expires on the same date. Let's say you receive a premium of $200 for selling this call.

Because the income from the call ($200) perfectly matched the cost of the put ($200), you have successfully created a costless collar. For the next three months, you know that:

• Worst-Case Scenario: If Innovate Corp's stock crashes to $70, you can exercise your put and sell your shares for $90 each, protecting you from further loss.
• Best-Case Scenario: If the stock shoots up to $130, the buyer of your call option will exercise it, and you'll have to sell your shares for $115 each. You miss out on the gains above $115.
• Middle Ground: If the stock price stays between $90 and $115, both options expire worthless. You keep your stock, the collar cost you nothing, and you've had three months of peace of mind.

For a dyed-in-the-wool value investor, the best defense is a good offense—that is, buying a wonderful business at a significant margin of safety. We generally prefer to let our winning businesses run, believing that long-term compounding is the surest path to wealth. Fiddling with complex derivative products can often be more trouble than it's worth. However, collars aren't entirely without merit. They can be a sensible risk-management tool in very specific situations:

• Concentration Risk: If a huge portion of your net worth is tied up in a single stock (perhaps from a former employer), a collar can be a prudent way to hedge your bets without creating a massive tax liability.
• Short-Term Nerves: If you are certain a company's long-term prospects are intact but fear a short, sharp market panic, a collar can help you sleep at night without having to sell a great asset.

The fundamental trade-off of a collar—security for upside—is something a value investor must consider carefully. Are you willing to cap the unlimited potential of a truly great company just to soothe short-term fears? Often, the answer is no. But for those rare occasions where you need to protect a life-changing gain from a sudden storm, a collar can be a useful tool to have in your financial shed. Just be sure you understand exactly how it works before you start building any fences.