Posted On March 13, 2020
Have you ever wondered how you could buy a call or a put, but not take a big loss if the market stagnant or the market does not reach the strike that you purchased? Well you can if you enter into a strategy referred to as a collar. A collar, which is also known as a risk reversal or a fence is when an investor purchases a call and sells a put or purchases a put and sells a call.
The main goal in entering into collar options strategy is to offset the cost of the premium for the option that you are purchasing buy selling another option. If an investor is able to completely offset the premium from the option that is purchased, the collar is referred to as a costless collar. An example of a costless collar is as follows. An investor purchases a IBM $90 call when IBM is trading at $85. For the sake of this example, let’s assume that the price (premium) of the call option is currently $2 for a 1 month option. Simultaneously, the investor sells an $80 put which also has a price of $2 (for the same time period), which will completely offset the premium for the call option. In this case the collar will be called a costless collar.
When trading a collar in the financial markets, investors can either construct these strategies one leg at a time, or they can ask for quotes on collars with specific legs. A Collar can also be constructed where the investor receives premium, or they can be contrasted where the investors pays away some premium. The benefit of paying away some money in premium when designing a collar is that the investor will minimize some of his risk by selling an option that is further out of the money. If we look at the prior example, an investor would wind up paying some premium if instead of selling an $80 put; the investor sold a $78 put. In this example, the investor might purchase a $90 call option, for $2, and sell a $78 put option for $1.50. The premium that the investor would need to pay is .50 ($2 – $1.50 = .50).
The benefit on this collar, would be that the investor would not be subject to being exercised on a $80 put, but would have some more room down to $78. Selling options is a risky strategy. When selling options, the seller or writer of the option has the obligation to either purchase or sell the underlying market at the level of the strike for the option that was sold (if the buyer of the option exercises the option). In a collar strategy, one leg of the option is purchase, and simultaneously another leg is sold. In the example above, if the market moves from $85 to $78, the investor would lose the premium on the call that was purchased, and would also be subject to exercise on the put that was sold. The benefit of this strategy is that if the market moves higher IBM say to $95, the call that is purchased at 90 would be in the money, and the investor did not have to lay out any money to purchase the call.
A collar is a very interesting a profitable strategy, but requires robust knowledge the options markets. The benefit is that the investor does not have to lay out a lot of money on premium to take a view of the market. Additionally, the risk the investor takes on implied volatility is greatly reduced. Implied volatility is an input into an option pricing model that is an assumption of how much the market believes an underlying asset will move until the expiration of the option on an annualized basis. The higher the implied volatility for an option, (all else being equal), the higher the cost of an option. When an investor purchases a call, and sells a put, they mitigate the effect of falling implied volatility on their options trade.