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[Editor’s Note: Options strategies can be complex. They typically suit advanced investors and traders who understand the features, benefits and risks of options. More information on options is available at the ASX Options Knowledge Hub. Before using options – or to refresh your knowledge of options strategies - consider taking the free ASX online Options Course. Like any investment, options have risks you need to understand. It’s possible to lose the entire amount of principal invested in options, depending on the strategy chosen. Seek independent advice from a professional adviser before investing in options.] 

A collar strategy is an approach that can be used in moderately volatile markets when an investor's view of a specific holding is that the downside risk (the risk that the price of the security falls), exceeds the upside potential (the likelihood the price will increase). 

This strategy is generally used to protect against the downside risk through the purchase of a put option and reducing the cost of this protection by simultaneously selling a call option over the stock. 

However, this strategy also limits the potential upside if the stock’s price increases above the investor’s expectation. 

The put option acts as protection, allowing the investor to sell the underlying stock at a predetermined price if the stock price falls. 

At the same time, the covered call allows an investor to generate extra income from their stock and offset any decline in value of the stock. 

Remember that when selling an American-style call option, there is a risk of an early assignment, especially when there is a dividend during the collar strategy’s lifetime [Editor’s note: Dividend payments can influence the likelihood of an option being exercised early].

Trade-offs and risks

Typically, a collar strategy is established for a small credit, zero-cost, or a small debit. The trade-off here is that the investor has capped their upside exposure of the underlying stock by the strike price of the call option. 

A collar strategy may not be suitable if the underlying expectation is that the stock price will rise strongly, as any increase above the strike price will be forgone.

The strike prices of the bought put option and covered call, or the cap and floor, can be tailored to the investor’s view of the stock which will ultimately determine the cost/benefit the investor is willing to accept for the volatility reduction for the stock holding. The collar can represent varying degrees of upside expectation depending on the strike the call is sold at. The further out-of-the-money the call strike, the more bullish the position is. The strike price for the bought put can be varied to meet the desired level of downside protection.

A collar strategy ensures that the maximum potential loss is the premium paid for the put, less the premium earned from the call, plus any loss in the underlying stock until reaching the floor (the strike price of the put option). 

Speculative Example

[Editor’s note: Do not read the following example as a recommendation to use an options strategy over FMG or other mining stocks. Do further research of your own and speak to a licensed financial adviser before using an options strategy].

Listed below is a speculative example of collar strategy using Fortescue Metals Group (ASX: FMG) which traded at a credit (the income received from the sold call was greater than the cost of the bought put):

  • Buy 1,000 FMG at $19.15
    • Buy 10 FMG $17.00 put option Dec-22 expiry for $1.02 (paid)
    • Sell 10 FMG $20.50 call option Dec-22 expiry for $1.12 (received)
    • Total Premium = $0.10 (received)

FMG is trading at $20.00 on the expiry day (Dec-22) 

  • The protective put is far out-of-the-money and therefore is worthless as the price of FMG is well above the strike price.
  • The covered call is closer to being in-the-money. However, there is risk of assignment as the current price is slightly lower than the strike price, meaning the option owner can buy the underlying units cheaper in the market.
  • The profit consists of the credit for opening the collar as well as the gain made on the FMG shares.
  • The profit incurred here is ($1.12 - $1.02) x 10 contracts x 100 shares per contract + ($20.00 - $19.15) x 1,000 shares = $950.00

If FMG were to be trading lower at $16.50:

  • The protective put would be in-the-money as the stock is trading below the strike price and the underlying FMG shares are sold at the strike price of $17.00.
  • The covered call is out-of-the-money and has no value as the share price is well below the strike price. 
  • The shares are now worth $16.50, and the potential loss would have been $2.65 per share or $2,650.00 total, if there was no protective put option in place.
  • The actual loss incurred here is $19.15 – ($17.00 – ($1.02 - $1.12)) = $2.05 x 10 contracts x 100 shares per contract = $2,050.00

Lastly, if FMG were to be trading higher at $21.00:

  • The protective put is out-of-the-money and is worthless as the share price is well above the strike price.
  • The covered call is now in-the-money, as the share price is above the strike price, the buyer would exercise the option subsequently selling the underlying FMG shares at the strike price of $20.50
  • The potential profit here has been capped at the strike price of the call option, and the net premium received for opening the collar will be retained.
  • The profit incurred here is ($20.50 – ($1.02 - $1.12)) - $19.15 = $1.45 x 10 contracts x 100 shares per contract = $1,450.00.
  • If no collar was in place, the potential profit would have been ($21.00 - $19.15) x 1,000 = $1,850.00. This shows that by having this strategy in place the potential profit has been limited to a maximum of $1,450.00 regardless of how high the price of FMG goes.

Source: CommSec


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