Collars

A covered call leaves you with all of that downside risk. A protective put is nice, but it costs money. So what to do? One idea is to put the two together.

If you own stock and you sell a call and buy a put, then you have a __collar__. What underlying price movement would you be hoping for in this case?

Not really. That would cause a loss in the stock position.

Absolutely. You're still a stockholder, and a higher price is better. It's just that with the collar, you really won't care if the price rises beyond the exercise price of the call option. So this is a bullish position. You could create a short collar by holding everything in reverse: a short stock, a short put, and a long call.

Actually, it would. Price movements are neutralized past the exercise prices, but you're still going to have a preference on the price movements within this range.

But back to the long collar. You might, for example, purchase a stock at a price of 50, with the following options available: | Exercise Price | Call option | Put option | |---|-----|-----| | 45 | 9.10 | 1.10 | | 50 | 4.90 | 4.80 | | 55 | 1.20 | 9.00 | You can sell off the upside past 55 with a short call and buy protection for a price below 45 with a long put. What happens to your cash?

That's off. Make sure that you're thinking about purchasing the put and selling the call.

Right! You'll actually come out a little ahead at the start of this strategy. You get 0.10 in net, which means that your breakeven price is just 0.10 lower, or 49.90. Obviously, your worst-case scenario is a price of 45 or below, and there you'll have a maximum loss of 4.90, since you lose 5 on the stock while getting that premium difference.

No. You're not purchasing both. You're buying the put and selling the call.

Your best-case scenario is a price of 55 or above. What would your profit be in this case?

Not exactly. You'd actually profit 5.10.

Absolutely.

You'll gain the price difference of 5 here, and the 0.10 premium difference is still yours to keep. The profit diagram looks like this:  What else does this look like?

If these option premiums offset exactly, it's called a __zero-cost collar__. That's often a goal of traders who do this. In this example, there was a small difference, and that's common. But if the difference is close enough to 0 to be ignored, then the profit function of a zero-cost collar is $$\displaystyle \Pi = X_1 - S_0 ~~ if~~ S_T \leq X_1 $$ $$\displaystyle \Pi = S_T - S_0 ~~ if~~ X_1 < S_T < X_2 $$ $$\displaystyle \Pi = X_2 - S_0 ~~ if~~ S_T \geq X_2 $$. The breakeven price here is just the starting price. It's a somewhat bullish setup, but it's also fairly neutral.

Exactly. It's the same shape. With the right prices, a bull spread could be built as a long collar.

Not quite. A short collar would look like that, though.

No. A butterfly spread is even on the upside and downside. That's not the case here.

To summarize: [[summary]]

A lower price

A higher price

It wouldn't matter

You pay 0.10

You get 0.10

You pay 2.30

4.90

5.10

A bull spread

A bear spread

A butterfly spread

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