Collar – is an option strategy that limits the range of possible positive or negative returns on an underlying asset to a specific range.
Consider an investor who owns one hundred shares of ABC stock for $10 a share. This investor can put a “collar” on this holding by buying one put with a strike price of $8 and selling one call with a strike price of $12. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2.
There are three possible scenarios when the options expire:
- If the stock price is above the $12 strike price on the call the investor wrote, the buyer of the call will exercise the purchased call. The investor effectively sells his shares at the $12 strike price. This would lock in a $2 profit for the investor. The investor can only make $2 profit (minus fees) on this collar regardless of how high the stock price goes.
- If the stock price drops below the $8 strike price on the put then the investor may exercise the put and the seller of the put must buy the shares at $8. The investor loses $2 on the stock, but can only lose $2 (plus fees), no matter how low the price of the stock goes.
- If the stock price is between the two strike prices at the expiration date, both options expire unexercised, and the investor is left with the 100 shares whose value is that stock price, minus fees.
