What Is a Collar in Options and How Does It Work?

Managing potential stock price movements is a common concern for investors. Options are financial contracts that provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. These instruments offer flexibility, allowing investors to tailor their market exposure. A “collar” is one such strategy, combining different options with an existing stock position to define a range of potential outcomes for the investment.

Understanding the Components of a Collar

A collar strategy begins with an investor who already owns shares of a company’s stock. This existing ownership is referred to as a “long position” in the underlying stock. The stock itself represents a share of ownership in a company, granting a claim on its assets and earnings. Investors typically hold stock with the expectation that its value will increase over time.

To implement a collar, the investor then buys a specific type of option known as a “long put option.” A put option gives the holder the right to sell a specified amount of the underlying stock at a fixed price, known as the strike price, before or on its expiration date. By purchasing a put, the investor establishes a “floor” for their stock, providing protection against a significant decline in its market value. The premium paid for this put is the cost of this downside insurance.

Simultaneously, the investor sells a “short call option” against their existing stock shares. A call option gives the buyer the right to purchase the underlying stock at a specified strike price. When an investor sells a call option, they receive a payment, known as a premium, from the buyer. This premium helps offset the cost of the protective put option. Selling a call option, however, obligates the seller to deliver their shares if the stock price rises above the call’s strike price, effectively establishing a “ceiling” on the stock’s potential upside.

How a Collar Strategy Works

The essence of a collar strategy lies in the simultaneous execution of these three positions: owning the underlying stock, purchasing a protective put option, and selling a covered call option. This combination creates a defined risk and reward profile for the investor. The strike price chosen for the purchased put option dictates the lowest price at which the investor’s stock can be sold, thus setting a maximum potential loss from a price decline. For example, if an investor owns stock trading at $100 and buys a put with a strike price of $90, their downside risk is generally limited to the stock falling below $90, plus the cost of the put.

Conversely, the strike price of the sold call option determines the highest price at which the stock could be sold. If the stock’s market price rises above the call’s strike price, the call buyer may exercise their right, requiring the investor to sell their shares at the call’s strike price. For instance, if the same stock is trading at $100 and the investor sells a call with a $110 strike, their upside gain is generally capped at $110, plus the premium received.

A significant aspect of the collar strategy is the premium received from selling the call option. This premium helps to reduce or even fully cover the cost of buying the protective put option, making the downside protection more economically efficient.

Within the range established by the put’s strike price and the call’s strike price, the stock’s value can fluctuate, and the investor retains full ownership and benefits from any appreciation. If the stock price falls below the put’s strike, the put provides protection, while if it rises above the call’s strike, the call caps the potential profit.

Scenarios for Using a Collar Strategy

Investors often employ a collar strategy when they hold a substantial unrealized gain in a stock position and wish to protect that profit without selling the shares outright. Selling the stock would immediately trigger a capital gains tax liability, which investors may prefer to defer. By implementing a collar, they can safeguard a portion of their accumulated gains against a market downturn while retaining ownership.

Another common use for a collar is when an investor anticipates potential short-term volatility or a market correction but still maintains a long-term positive outlook on the stock. The strategy provides a predefined limit on potential losses, offering peace of mind during uncertain periods. This allows the investor to participate in some upside potential while knowing their downside exposure is managed.

The income generated from selling the call option is also a compelling reason to use a collar. This premium can effectively reduce the overall cost of the strategy, making the purchase of the protective put more affordable. In some cases, the premium received from the call can even exceed the cost of the put, resulting in a net credit to the investor. This makes the risk management aspect of the collar more capital-efficient.

Maintaining ownership of the underlying stock is a key benefit of the collar strategy. Investors might want to retain shares for various reasons, such as receiving dividends, exercising voting rights, or simply adhering to a long-term investment philosophy. A collar allows them to manage short-term risk without relinquishing their stake in the company. For tax purposes, gains and losses from equity options are reported on IRS Schedule D and Form 8949. Investors typically report profits as either long-term or short-term gains based on how long they held the position.