Collar Option Trading Strategy
The collar option trading strategy provides a conservative approach for traders who want to protect their underlying asset from losses while still benefiting from a bullish market view. It involves combining a covered call position with the purchase of a protective put option. The collar strategy is low-risk, as the put option acts as insurance against potential downside risks, albeit with limited rewards.
Understanding the Collar Strategy
Within the intricate tapestry of trading, the collar strategy emerges as a delicate equilibrium. Traders skillfully choreograph the sale of an out-of-the-money (OTM) call option in symphony with the acquisition of an at-the-money (ATM) put option, aligning the quantity of shares they possess. This harmonious interplay orchestrates a two-fold outcome: firstly, the generation of income from the call option; secondly, a vigilant safeguarding mechanism against the specter of potential price downturns through the put option.
When to Use the Collar Strategy
The collar strategy is ideal for traders who seek protection against losses on their underlying asset while maintaining a conservatively bullish view of the market.
Example: Implementing the Collar Strategy
Let’s consider an example where you own shares of HDFC (Housing Development Finance Corporation Limited) currently trading at Rs. 250. To employ the collar strategy, you can sell a call option with a strike price of Rs. 300 and simultaneously purchase a put option with a strike price of Rs. 200. The net premiums for the options will determine your potential profits and losses.
|HDFC Current Trading Price and Options Details|
|HDFC Current Trading Price:||Rs. 750|
|Call Option Strike Price:||Rs. 30|
|Premium Received:||Rs. 4|
|Put Option Strike Price:||Rs. 20|
|Premium Paid:||Rs. 3|
|Net Premium:||Rs. 1|
|Break Even Point:||(Price of Underlying + Call Premium + Put Premium) = Rs. 26|
Possible Scenarios with Collar Strategy
Scenario 1: The price of HDFC increases to Rs. 5100
In this context, your holdings’ value ascends to Rs. 500, resulting in a profit of Rs. 22 (Rs. 500 – Rs. 478). Post deducting the net premium of Rs. 10, your cumulative profit stands at Rs. 23. As expiration nears, the put option holds no value, while Rs. 100 becomes due for the call option. Balancing these elements, your net profit sums up to Rs. 13.
Scenario 2: Price drops to Rs. 4600
If the price drops to Rs. 460, you will experience a loss of Rs. 18 in the value of your holdings. However, the put option will earn you Rs. 10. The call option will be worthless at expiration. Post deduction of the net premium of Rs. 1, the composite loss amounts to Rs. 6.8.
Collar Option Strategy Payoff Schedule
|HDFC Closing Prices||Payoff for Short Call Option||Long Put Option Payoff||HDFC Payoff||Net Payoff|
Collar: Risk Profile
The collar strategy carries limited risk, and the maximum loss occurs when the price of the underlying stock is lower than the strike price of the put option.
Max Loss = Strike Price for Long Put – Purchase Price of Underlying Contract – Net Premium Received
Collar with Reward Profile
The collar strategy also provides limited rewards. Maximum profit is realized when the price of the underlying is higher than the strike price.
Max Profit = Strike Price of Short Call + Purchase Price of Underlying + Net Premium Received
Max Profit Scenario of Collar
Maximum profit is achieved when the call option is exercised and the underlying asset price increases.
Max Loss Scenario of Collar
Maximum loss occurs when the underlying asset falls, and the put option is exercised.
In conclusion, the collar option trading strategy is a valuable tool for traders who want to protect their positions from potential losses while maintaining a bullish market view. By combining a covered call position with a protective put, traders can limit their risks while still benefiting from favorable market movements. However, it is crucial to consider the strategy’s limited reward potential before implementing it in your investment portfolio.