Knowledge Base

What is a Collar Strategy?

in Trading Strategies
Tags: collar strategy

What if a share you own suddenly goes into a free-fall? Often, shares react drastically to negative news about the company, a big example being Kingfisher or even SpiceJet. If the descent continues, it could wreak havoc on your investments.

One strategy that you can use to protect your profits is called a Collar Strategy. It uses a combination of options contracts (derivative agreements that allow an investor to buy or sell an asset at a specific strike price on a future date) to protect investor profits.

Here is a look:

What is a Collar Strategy

Collar is a hedging strategy that involves buying an asset (such as a stock, index, commodity or currency). This is followed by the purchase of a put option (i.e. option to buy) and the sale of a call option (i.e. option to sell) on it, both having the same expiry date. Both the options are out-of-money options—the strike price of the put option is lower than the market price of the asset while that of the call option is higher than the market price. Neither contract is currently making any money.

Benefits of a collar strategy

A collar strategy is generally used by an investor who expects an asset to depreciate following a strong appreciation. The Put option allows him to lock his profit by selling the asset at a specific price below its current price, if it starts depreciating. By selling the out-of-money call option, the investor grants the buyer the right to buy the asset at a higher price than its current price. Since this is unprofitable to the counterparty, he will not exercise the option. However, seller of the call receives a premium (i.e. price of the option) for it. This offsets a similar premium he would paid for buying the Put option earlier, making his hedge cost-free.

Working of a collar strategy

Suppose you bought 100 shares of a company at Rs 50; they are currently trading at Rs 70. To protect his profit, you will buy a put option on these shares, with a strike price of say Rs 65. Now, even if the price falls below Rs 65, you will be able to sell the shares at Rs 65. For this privilege, you will pay a hypothetical premium of Rs 5 per share. Simultaneously, you will also sell a call option on the same shares at a strike price of say Rs 90. The asset is unlikely to reach this and so the call buyer will probably not exercise it. However, you will receive a premium of say Rs 4 per share for this. Thus, you will be able to protect most of your profit by paying a net premium of just Re 1 per share (Rs 100 in all). If the stock does not fall to Rs 65, you will let the option expire and lose only the net premium amount of Rs 100.

Collar strategy vs bracket order

The Collar strategy is similar to a Bracket Order. As part of the Bracket Order, you simultaneously purchase an asset as well as place two orders to sell it—one above the purchase price (take-profit order) and another below it (stop-loss order). These assets are automatically sold when they reach one of these two prices, whichever happens first. If the asset depreciates, you loss will be limited to the stop loss, just as in a Collar.

However, the Collar strategy has an advantage of the Bracket Order. It is more cost-effective. Since premiums on the two options almost completely offset each other, the protection you get is almost free. In case of a Bracket Order, you have to pay brokerage on the underlying orders.