What Is a Collar Trade and How Does It Work?

A collar trade is an options strategy for investors who already hold shares of a particular stock. This approach aims to protect existing gains or generate additional income. By combining financial instruments, the strategy seeks to limit potential losses if the stock price declines. It is considered a conservative strategy, designed to manage risk while retaining some exposure to the underlying asset.

What is a Collar Trade?

A collar trade is an options strategy that combines three distinct elements: an investor’s existing stock ownership, a purchased protective put option, and a sold covered call option. This combination creates a defined range within which potential profits and losses are contained.

The primary purpose of a collar trade is to hedge against downward movements in the price of the owned stock. The purchased put option provides a floor for potential losses, limiting the investor’s exposure to a predetermined level. Simultaneously, the sale of the covered call option helps finance the cost of buying the protective put and defines the maximum potential upside gain on the stock during the options’ life.

Investors typically use a collar trade when they have accumulated substantial gains in a stock but are concerned about a potential price correction. It allows them to lock in a portion of their profits without fully selling shares, which might trigger immediate capital gains taxes. The strategy creates a “collar” around the stock’s price, protecting against drops while capping further appreciation for a specific period.

Components of a Collar Trade

The strategy is constructed from three distinct components: the underlying stock, a protective put option, and a covered call option. Each component plays a specific role in defining the risk and reward profile of the entire position.

The foundation of any collar trade is the investor’s existing ownership of shares in a particular stock. This ownership is a prerequisite because the strategy manages the risk associated with an already held equity position. Without owning the underlying stock, an investor cannot execute a “covered” call, which is a fundamental part of the collar structure.

The second component is the protective put option, which the investor purchases. A put option grants the holder the right, but not the obligation, to sell a specified number of shares of the underlying stock at a predetermined strike price on or before a specific expiration date. In a collar trade, this put provides downside protection; if the stock price falls below the put’s strike price, the investor’s losses are largely mitigated because they can sell their shares at the higher strike price. The strike price for this put is typically chosen below the current market price (out-of-the-money), and its expiration date is usually set for the near future, such as one to three months out.

The third component is the covered call option, which the investor sells. A call option grants the holder the right, but not the obligation, to buy a specified number of shares of the underlying stock at a predetermined strike price on or before a specific expiration date. When an investor sells a call option against shares they already own, it is termed a “covered call” because the owned shares “cover” the obligation to deliver the stock if the call option is exercised. The premium received from selling this call helps offset the cost of buying the put option. The strike price is generally chosen above the current market price (out-of-the-money). Both the put and the call options typically share the same expiration date to simplify management.

Constructing a Collar Trade

Constructing a collar trade involves holding the underlying equity. An investor must possess at least 100 shares of the stock for each options contract, as standard options contracts typically represent 100 shares. This ownership forms the basis for the “covered” aspect of the strategy.

After confirming stock ownership, the investor buys a protective put option. Selection involves two primary considerations: the strike price and the expiration date. Investors commonly choose an out-of-the-money strike price (below the current market price) to define their maximum acceptable loss. The expiration date for this put is typically chosen for a period in the near future, such as three to six months out, aligning with the investor’s short-term outlook.

Simultaneously or shortly thereafter, the investor sells a covered call option against their owned shares. Similar to the put, the selection of the call involves choosing a strike price and an expiration date. The strike price for the sold call is generally selected out-of-the-money (above the current stock price) and also above the purchased put’s strike price. This establishes the ceiling for potential gains. It is common practice for the sold call option to have the same expiration date as the purchased put option, simplifying the overall position’s management.

The financial interaction of these two options transactions determines the collar’s net premium. The premium received from selling the call option helps reduce or entirely offset the cost of purchasing the put option. Investors often aim to construct a “zero-cost” collar, where the premium from the sold call equals or exceeds the premium paid for the bought put, effectively creating a hedge without an upfront cash outlay. This careful selection allows the investor to tailor the collar to their specific risk tolerance and market outlook.

Outcomes of a Collar Trade

The financial outcomes of a collar trade are directly influenced by the movement of the underlying stock price relative to the options’ strike prices. This strategy defines a clear range of potential profits and losses, offering predictability to the investor.

If the stock price rises significantly above the sold call option’s strike price, the investor’s profit potential is capped. The gain on the overall position is limited to the difference between the stock’s purchase price and the call option’s strike price, plus any net premium received, minus the put’s cost. The sold call option will likely be exercised, obligating the investor to sell their shares at the call’s strike price, preventing them from participating in further upside appreciation. In this scenario, the protective put option will expire worthless, as the stock price is well above its strike price.

Conversely, if the stock price falls substantially below the purchased put option’s strike price, the investor’s losses are largely contained. The put option provides a safety net, allowing the investor to sell their shares at the put’s strike price, even if the market price is lower. The maximum potential loss is generally limited to the difference between the stock’s purchase price and the put option’s strike price, plus any net premium paid, or minus any net premium received. The sold call option will expire worthless, as the stock price is far below its strike price.

Should the stock price remain relatively flat, staying between the strike prices of the put and call options, the outcome is often favorable for the investor. In this situation, both the purchased put and the sold call options may expire worthless, allowing the investor to retain the entire net premium collected from the trade. This scenario generates income without requiring them to sell their shares or incur significant losses.

The maximum potential profit for a collar trade is generally defined as the call strike price minus the stock purchase price, plus the net premium received. The maximum potential loss is the stock purchase price minus the put strike price, plus the net premium paid. The breakeven point is typically calculated as the stock purchase price plus the net premium paid, or minus the net premium received.