There are many different option strategies that investors can use when it comes to protecting their portfolios. In times of high volatility, which seems to be the current market theme, collars can be used to limit the downside risk to a portfolio. There are numerous ways to use collars by buying and selling a combination of puts and calls but the end result will always keep losses and gains on a stock within a specific range.
One of the best features of using collars is that the cost of implementing this strategy is "free" or close to it. It is considered "free" because you use the price you receive for selling a call to buy a put. In some cases, it is even possible to receive a credit into your account. Here's how they work.
Let's say you own 100 shares of Microsoft (MSFT) which is currently trading around $28.75. Regardless if you have owned the stock for years or a matter of weeks, when you use a collar strategy, you will know that your expected return can be no higher than the return defined by what strike price you use on the call, if exercised. You will also know that your expected loss can be no higher than the loss that results from the strike price of the put, if exercised.
A May call on Microsoft with a strike price 30 (MSQGK) is currently trading at 65 cents. A May put with a strike price of 27.50 (MSQSY) is currently trading at 50 cents. If you sell the call, you would receive $65 in you account. You would then buy the put for $50, leaving you with a net credit. Of course, one must consider commission costs, so there may or may not be a net credit depending on who you use as a broker. Either way, by employing this strategy, your gain on Microsoft will be no higher than $1.25 and your loss will be no worse than $1.25, by selling the call and buying the put.
Here's how it would play out:
1) If Microsoft is above $30, the call you sold will be exercised and you will have to sell your shares at $30. The most you can make is the $1.25 profit or $125 for every 100 shares.
2) If Microsoft is below $27.50, you could exercise your put and sell your shares at $27.50. The most you would lose is the $1.25 or $125 for every 100 shares no matter how low the price of the stock goes.
3) If Microsoft is between $27.50 and $30 by the May expiration date, both options expire unexercised, and you are left with your shares of Microsoft.
There are certainly other benefits of using collars to where you can get
an even much better reward-to-risk ratio than the example I just used but you will have to do your homework. Just remember, your returns are likely to be somewhat limited because by selling a call, you give up the right for further appreciation beyond the strike price of the call you sold. However, your losses will also be limited because of the protection you have by buying the put.
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