Equity Collar
[edit] Structure
A collar is created by an investor being:[1]
- Long the underlying
- long a put option at strike price X (called the "floor")
- Short a call option at strike price (X+a) (called the "cap")
These latter two are a short Risk reversal position. So:
- Underlying - Risk reversal = Collar
The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. If the premium of the short call is exactly equal to the cost of the put, the strategy is known as a 'zero-cost collar. [Strictly speaking the name should be 'zero-premium collar' since the cost of holding the position may be high if the price of the underlying rises above the strike level of the call.]
On expiry the value (but not the profit) of the collar will be:
- zero if the price of the underlying is below X
- positive if the price of the underlying is between X and (X + a)
The maximum value occurs for any price of the underlying above X+a.
[edit] Example
Consider an investor who owns one hundred shares of a stock with a current share price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option, i.e. the cost of the put option less what is received for selling the call option).
There are three possible scenarios when the options expire:
- If the stock price is above the $7 strike price on the call he wrote, the person who bought the call from the investor will exercise the purchased call; the investor effectively sells the shares at the $7 strike price. This would lock in a $2 profit for the investor. He only makes a $2 profit (minus fees), no matter how high the share price goes. For example if the stock price goes up to $9, the buyer of the call will exercise the option and the investor will sell the shares that he bought at $5 for $9, for a $4 profit, but must then pay out $9–$7=$2, making his profit only $2.
- If the stock price drops below the $3 strike price on the put then the investor may exercise the put and the person who sold it is forced to buy the investor's 100 shares at $3. The investor loses $2 on the stock but can lose only $2 (plus fees) no matter how low the price of the stock goes. For example if the stock price falls to $1 then the investor exercises the put and has a $2 gain. The value of the investor's stock has fallen by $5–$1 = $4. The call expires worthless (since the buyer does not exercise it) and the total net loss is $2–$4= -$2.
- If the stock price is between the two strike prices on the expiry date, both options expire unexercised and the investor is left with the 100 shares whose value is that stock price (x100), plus the cash gained from selling the call option, minus the price paid to buy the put option, minus fees.
One source of risk is counterparty risk. If the stock price expires below the $3 floor then the counterparty may default on the put contract, thus creating the potential for losses up to the full value of the stock (plus fees).
