How a Protective Collar Works

When the markets start swinging wildly, investors often run for safety as volatility creates fear among market participants. But, there is no need to panic! A protective collar is an options strategy that could provide short-term downside protection, offering a cost-effective way to protect against losses and allowing you to make some money when the market goes up. Here, we go over the mechanics of initiating this hedging strategy.

The Protective Collar Strategy

A protective collar consists of:

1. a long position in the underlying security
2. a put option purchased to hedge the downside risk on a stock
3. a call option written on the stock to finance the put purchase.

Another way to think of a protective collar is as a combination of a covered call plus long put position.

Both the put and call are typically out-of-the-money (OTM) options, and must have the same expiration. The combination of the long put and short call forms a "collar" for the underlying stock that is defined by the strike prices of the put and call options. The "protective" aspect of this strategy arises from the fact that the put position provides downside protection for the stock until the put expires.

Since the basic objective of the collar is to hedge downside risk, it stands to reason that the strike price of the call written should be higher than the strike price of the put purchased. Thus if a stock is trading at $50, a call on it may be written with a strike price of say $52.50, with a put purchased with a strike price of $47.50. The $52.50 call strike price provides a cap for the stock's gains, since it can be called away when it trades above the strike price. Likewise, the $47.50 put strike price provides a floor for the stock, as it provides downside protection below this level.

When to Use a Protective Collar

A protective collar is usually implemented when the investor requires downside protection for the short- to medium-term, but at a lower cost. Since buying protective puts can be an expensive proposition, writing OTM calls can defray the cost of the puts quite substantially. In fact, it is possible to construct protective collars for most stocks that are either "costless" (also called "zero-cost collars") or actually generate a net credit for the investor.

The main drawback of this strategy is that the investor is giving away upside in the stock in exchange for obtaining downside protection. The protective collar works like a charm if the stock declines, but not so well if the stock surges ahead and is "called away," as any additional gain above the call strike price will be lost.

Thus, in the earlier example where a covered call is written at $52.50 on a stock that is trading at $50, if the stock subsequently rises to $55, the investor who has written the call would have to surrender the stock at $52.50, forgoing an additional $2.50 in profit. If the stock advances to $65 before the call expires, the call writer would forgo an additional $12.50 (i.e., $65 minus $52.50) in profit, and so on.

Protective collars are particularly useful when the broad markets or specific stocks are showing signs of retreating after a sizable advance. They should be used with caution in a strong bull market, as the odds of stocks being called away (and thus capping the upside of a specific stock or portfolio) may be quite high.

Constructing a Protective Collar

Let's understand how a protective collar can be constructed using a historical example from options on Apple, Inc. (AAPL), whose shares closed at $177.09 on Jan. 12, 2018. Assume you hold 100 shares of Apple that you purchased at $90, and with the stock up 97% from your purchase price, you would like to implement a collar to protect your gains without actually selling your shares outright.

You start by writing a covered call on your Apple position. Let's say for example that the March 2018 $185 calls are trading at $3.65 / $3.75, so you write one contract (that has 100 AAPL shares as the underlying asset) to generate premium income of $365 (less commissions). You concurrently also buy one contract of the March 2018 $170 puts, which are trading at $4.35 / $4.50, costing you $450 (plus commissions). The collar thus has a net cost, excluding commissions, of $85.

Scenario Analysis

Here's how the strategy would work out in each of the following three scenarios:

Scenario 1 – Apple is trading above $185 (say $187) just before the March 20 option expiration date.

In this case, the $185 call would be trading at a price of at least $2, while the $170 put would be trading close to zero. While you could easily close out the short call position (recall that you received $3.65 in premium income for it), let's assume that you do not and are comfortable with your Apple shares being called away at $185.

Your overall gain would be:

[($185 - $90) - $0.85 net cost of the collar] x 100 = $9,415

Recall what we said earlier about a collar capping upside in the stock. If you had not implemented the collar, your gain on the Apple position would have been:

($187 - $90) x 100 = $9,700

By implementing the collar, you had to forgo $285 or $2.85 per share in additional gains (i.e., the $2 difference between $187 and $185, and $0.85 collar cost).

Scenario 2– Apple is trading below $170 (say $165) very shortly before the March 20 option expiration.

In this case, the $185 calls would be trading close to zero, while the $170 puts would be worth at least $5. You then exercise your right to sell your Apple shares at $165, in which case your overall gain would be:

[($170 - $90) - $0.85 net cost of the collar] x 100 = $7,915

If you did not have the collar in place, the gain on your Apple shares would only be $7,500 (i.e., the difference between the current price of $165 and the initial cost of $90 x 100 shares). The collar thus helped you realize an additional $415 by providing downside protection for your AAPL holding.

Scenario 3– Apple is trading between $170 and $185 (say $177) very shortly before the March 20 option expiration.

In this case, the $185 call and $170 put would both be trading close to zero, and your only cost would be the $85 incurred in implementing the collar. 

The notional (unrealized) gain on your Apple holding would then be

$8,700 ($177 - $90) less the $85 cost of the collar, or $8,615

Tax Advantages of a Collar

A collar can be an effective way to protect the value of your investment at possibly a zero net cost to you. However, it also has some other points that could save you (or your heirs) tax dollars.

For example, what if you own a stock that has risen significantly since you bought it? Maybe you think it has more upside potential, but you're concerned about the rest of the market pulling it down.

One choice is to sell the stock and buy it back when the market stabilizes. You might even be able to get it for less than its current market value and pocket a few additional bucks. The problem is, if you sell, you'll have to pay capital gains tax on your profit.

By using the collar strategy, you'll be able to hedge against a market downturn without triggering a taxable event. Of course, if you're forced to sell your stock to the call holder or you decide to sell to the put holder, you'll have taxes to pay on the profit.

You could possibly help your beneficiaries, too. As long as you don't sell your stock, they'll be able to take advantage of the step-up in basis when they inherit the stock from you.

The Bottom Line

A protective collar can be a good strategy for gaining downside protection in a more cost-effective way than merely buying a protective put. This is achieved by writing an OTM call on a stock holding and using the premium received to buy an OTM put. The trade-off is that the overall cost of hedging downside risk is cheaper, but upside potential is capped.