Collar

Think: Fifty Shades...

Okay, okay. There are a lot of twists and turns in a collar option strategy, so hang on to your hats as we go through it step by step.

It all starts with the investor deciding to buy a long position on a stock, meaning he or she expects that it will rise in value. Just as a collar can help protect your pet, a collar option strategy can protect the investor in case the price of a stock drops. At the same time that the investor purchases a call option that is “out of the money” (meaning at a higher price than the current market price), he or she purchases an out-of-the money put option. (Call means the investor expects the price to go up, while put means they expect it to go down.) Both options contracts should be for the same quantity and have the same expiration date. If the price does drop, the investor is protected with the put option, and if it goes up, he or she will earn a profit, up to their designated strike price (the price the investor thinks it will go up to).

Amy is feeling mildly bullish, but wants to protect herself from a price drop on a particular stock. She is also willing to play it conservatively and not worry that she could be missing out on some profit if the stock goes above her strike price.

So Amy takes a long position of 2,000 shares of Ring Around the Collar Inc. at a price of $60 per share. Currently, Ring is trading at $57 per share. The market is a little volatile at the moment, so she decides to do a collar option.

First she purchases 20 call options with a strike price of $70, and 20 put options with a strike price of $55. The maximum profit Amy could get is $20,000, or 20 contracts x 100 shares x ($70-$60). This would only happen if the stock price goes to $70 or above.

The maximum loss would be $10,000, or 20 x 100 x ($60-$55). This loss would happen if the stock price drops to $55 or below. So Amy sleeps well knowing she has hedged her bets.