The protective collar strategy is a popular risk management tool among investors who want to protect their gains while limiting potential losses. It involves three key components: owning the underlying asset, purchasing an out-of-the-money (OTM) put option, and writing an OTM call option with the same expiration date. Let’s break down the strategy step-by-step and explore its nuances, benefits, and drawbacks. Mechanics:
You must already own the stock or asset you want to protect. For example, you hold 100 shares of ABC Corporation, currently trading at $100 per share.
Buy a put option with a strike price below the current market price of the stock. This put option acts as insurance, giving you the right to sell your shares at the strike price. In our example, you buy an ABC March 95 put option. This means you can sell your shares at $95, regardless of how low the stock price falls.
Sell a call option with a strike price above the current market price. This generates income (premium) but obligates you to sell your shares at the strike price if the option is exercised. In our example, you sell an ABC March 105 call option. If ABC’s stock price rises above $105, you must sell your shares at $105.
Equity collars are used by investors whose primary concern is the downside risk of a stock position. They are willing to place a cap on upside potential to limit their downside risk at little, and sometimes no cost. The primary benefit is the downside protection offered by the long put option. If ABC’s stock price falls below $95, your losses are limited because you can sell your shares at $95. Research by Whaley (2002) in “Derivatives on Market Volatility” shows that protective collars can be effective in reducing portfolio volatility.
Writing the call option generates premium income, which can offset the cost of purchasing the put option. This makes the protective collar a cost-effective strategy.
This strategy is particularly useful after substantial gains in the underlying asset. It allows you to lock in profits while still participating in some upside potential.
Zero-Cost Collar Strategy with 2% OTM: A Preferred Choice Amid Market Anxiety The main trade-off is the potential obligation to sell your shares at the call option’s strike price ($105 in our example). If ABC’s stock price rises significantly above $105, you miss out on those additional gains. Implementing a protective collar strategy involves multiple transactions, which can lead to brokerage fees and requires careful management. The risk associated with collar strategies is generally high, particularly during bullish market periods. It’s crucial to account for the potential losses from call exercises. Research by El-Hassan (2021)99 examined various approaches for setting OTM call and put prices. The study found that while complex strategies, which analyze market and economic signals (referred to as New and Active strategies), rank among the top three performing portfolios, a zero-cost collar strategy with a 2% OTM call and put, and a 6-month maturity, is generally preferable. In periods of high market anxiety, these complex strategies are less likely to succeed. Zero-cost collar strategies tend to capture more market information than complex collar strategies. Unlike collar strategies, protective put strategies do not carry the risk of call exercise costs. The new strategy appears to gather more market information than active strategies overall, due to its consideration of volatility magnitude.
Writing a call option and buying a put option can have tax consequences. For example, the premium received from writing the call is considered taxable income. Additionally, if the call option is exercised, it may trigger a capital gains tax event.
Let’s revisit our example with ABC Corporation:
Long 100 shares of ABC at $100.
Buy ABC March 95 put for $2 per share (total cost = $200).
Sell ABC March 105 call for $2 per share (total premium = $200).
In this scenario, the net cost of the protective collar is zero because the premium from the call option offsets the cost of the put option.
You can exercise the put option and sell your shares at $95, limiting your loss to $5 per share.
You must sell your shares at $105, capping your gain but still locking in a $5 per share profit. If, after a few months, the stock price increases to $120, you might decide to adjust your collar by buying back the call option and selling another with a higher strike price, say $130, to maintain upside potential while still protecting your investment.
The protective collar strategy is a balanced approach to risk management, offering downside protection while allowing for some upside potential. It’s particularly useful for investors in high tax brackets who have already seen significant gains in their holdings. However, it requires careful consideration of costs, tax implications, and the potential for missed opportunities if the stock price rises significantly. Always stay informed and refer to empirical research and tax regulations to optimize your strategy.