How to Protect Your Stock Portfolio with Collar Strategy

In this article, we will discuss:

• What is a Collar Strategy?
• How Does a Collar Strategy Work?
• Collar Strategy Payoff Graph
• Who Can Deploy a Collar Strategy?
• When to Use a Collar Strategy?
• How to Use Strategy Greeks to Optimise Your Collar Strategy?
• What are the Things to Keep in Mind When Using a Collar Strategy?
• Conclusion

If you are an investor who owns or plans to buy a stock and wants to hedge your position against downside risk, while still maintaining some upside potential, you may want to consider using a collar strategy. 

What is a Collar Strategy?

A collar strategy is a combination of a protective put and a covered call. A protective put is an option strategy that involves buying a put option on a stock that you own or plan to buy. A put option gives you the right, but not the obligation, to sell the stock at a specified price (called the strike price) before a certain date (called the expiration date). A protective put can help you limit your losses if the stock price falls below the strike price.

How Does a Collar Strategy Work?

Let's take an example to illustrate how a collar strategy works. Suppose you own 100 shares of ABC stock, which is currently trading at Rs 500 per share. You are bullish on the stock, but you are also concerned about the market volatility and the possibility of a sharp decline in the stock price. You decide to use a collar strategy to protect your position and reduce your risk. You buy one put option with a strike price of Rs 450 and an expiration date of one month, and you sell one call option with a strike price of Rs 550 and an expiration date of one month. The put option costs you Rs 10 per share, and the call option pays you Rs 15 per share. The net cost of the collar strategy is -Rs 5 per share, or -Rs 500 for the whole position.

Now, let's see what happens at the expiration date of the options, depending on the stock price. There are three possible scenarios:

• Scenario 1: If the stock price is below Rs 450, both the put and call options are in-the-money. You can sell the stock at Rs 550 and buy it back at Rs 450, making a profit of Rs 9,500 after subtracting the collar strategy cost.
• Scenario 2: If the stock price is between Rs 450 and Rs 550, both options are out-of-the-money. Your net profit is Rs 1,500 after subtracting the collar strategy cost, with a 3% ROI.
• Scenario 3: If the stock price is above Rs 550, the put option is out-of-the-money and the call option is in-the-money. Your net profit is Rs 4,500 after subtracting the collar strategy cost, with a 9% ROI.

The following table summarises the payoff of the collar strategy at expiration, depending on the stock price:

The following graph shows the payoff of the collar strategy at expiration, depending on the stock price:

Collar Strategy Payoff Graph

As you can see, the collar strategy creates a range of possible outcomes for your stock portfolio, with a limited downside and a limited upside. The breakeven point of the strategy is the stock price that makes the net profit zero. In this example, the breakeven point is Rs 505, which is the initial stock price of Rs 500 plus the net cost of the collar strategy of -Rs 5.

Who Can Deploy a Collar Strategy?

A collar strategy can be used bytraders who own or plan to buy a stock and want to hedge their position against downside risk, while still maintaining some upside potential. A collar strategy can be especially useful for investors who are bullish on the stock, but are also concerned about the market volatility and the possibility of a sharp decline in the stock price. A collar strategy can also be used by investors who want to lock in some profits from a stock that has appreciated in value, without selling the stock and triggering capital gains tax. A collar strategy can also be used by investors who want to generate some income from the premium received from selling the call option, while also buying some protection from the put option.

When to Use a Collar Strategy?

A collar strategy can be used when you are bullish on the underlying stock, but you expect limited upside and significant downside risk. For example, you may use a collar strategy when:

• You own a stock that has performed well and you want to protect your profits, but you also want to participate in some future growth.
• You want to buy a stock that you are optimistic about, but you are also worried about the market uncertainty and the potential for a large drop in the stock price.
• You want to generate some income from the premium received from selling the call option, while also buying some protection from the put option.

How to Use Strategy Greeks to Optimise Your Collar Strategy?

In a collar strategy, the strike prices for buying the put option and selling the call option will be selected in such a way that the theta and vega of both these options will even out each other. Theta is the measure of how much an option's value decreases as time passes, and vega is the measure of how much an option's value changes with changes in volatility. By balancing the theta and vega of the options, you can minimise the effects of time decay and volatility on your collar strategy.

What are the Things to Keep in Mind When Using a Collar Strategy?

When using a collar strategy, you should keep the following things in mind:

• Since this strategy involves limited risk, there is no need to maintain a stop loss. However, you should monitor the stock price and the option prices regularly, and adjust your strategy if needed.
• Since this strategy is a complete hedge, you can trade with less margins as well. However, you should be aware of the margin requirements and the margin calls from your broker, and maintain sufficient funds in your account.
• To get the most out of the hedge benefits on margin, the sequence of order placement should be buying the put option, buying the future, and then selling the call option. This way, you can reduce the margin requirement of the strategy.
• You should also consider the tax implications of using a collar strategy, as the income from the call option and the gains or losses from the stock and the put option may be taxed differently, depending on your tax bracket and the holding period of the assets.

Conclusion

A collar strategy is a type of options strategy that can help you protect your stock portfolio from downside risk, while still maintaining some upside potential. Options B.R.O. integrated into the Samco trading app, is a proprietary options strategy builder. It assists traders in identifying optimal options strategies tailored to their market outlook, risk tolerance, and return expectations. Additionally, it evaluates market insights and options Greeks to rate and rank each strategy.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING. The asset classes and securities quoted in the film are exemplary and are not recommendatory. SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008 CIN No.: U67120MH2004PLC146183 | SAMCO Commodities Limited (Formerly known as Samruddhi Tradecom India Limited) | MCX- 55190 | SEBI Reg. No.: INZ000013932 Registered Address: Samco Securities Limited, 1004 - A, 10th Floor, Naman Midtown - A Wing, Senapati Bapat Marg, Prabhadevi, Mumbai - 400 013, Maharashtra, India. For any complaints Email - grievances@samco.in Research Analysts -SEBI Reg.No.-INHO0O0005847.