Understanding Collar

With this chapter, we're halfway through this module and we’ve seen some really good options trading strategies that you can use to experience some gains and limit your losses. Another popular options strategy - the collar - is going to be the focus of this chapter. Remember the protective put? That strategy forms a part of the collar. A strategy as a part of a strategy? Let’s see how that works.

What is the collar?

Also known as a hedge wrapper, the collar is an options trading strategy that’s generally used by traders to hedge short-term downside risks on a stock that they already own. In addition to limiting the losses, the collar trading strategy also limits your profits. The strategy is useful for times when traders feel that a particular stock has good long-term growth potential but suffers from high short-term downside risk.

How to set up a collar?

To set up a collar trading strategy, here are the steps that you need to follow.

• Firstly, you need to own the shares of a company with an active derivatives segment. 
• The next step is to sell an out of the money (OTM) call option contract of the stock. 
• And finally, you need to buy an out of the money (OTM) put option contract of the same stock.

When purchasing option contracts, always make sure that the lot size of the put options contract matches the total number of shares that you own. That’s not all. In order for the collar to work, the expiration month for both the contracts also needs to be the same.

How does the collar work?

As usual, we’ll take a look at an example to see how the collar options strategy works. But before that, let’s first lay down the assumptions that we’re going to make.

• You’re interested in the stock of Asian Paints Limited since you believe that it has a strong growth potential. 
• And so, you’ve bought 300 shares of the company at Rs. 2,500 per share. The total capital outlay comes up to Rs. 7,50,000 (Rs. 2,500 x 300). 
• However, despite the long-term bullish outlook, you feel that the short-term downside risk is high in this stock. 
• Therefore, you decide to use the collar trading strategy to minimize potential downside risk, even if it is at the cost of profits.  
• The lot size of the options contract of this stock is set at 300.
• The expiry date of all the options that we’re going to consider would be May, 2021.

Now, as you’ve seen before, there are two different options contracts in play. So, here’s what you would have to do in this example.

• Sell 1 lot of OTM call options of the stock, which in this case would be ASIANPAINT MAY 2600 CE. Let’s say that the premium for the call option is currently at Rs. 30 per share. Therefore, by selling 1 lot of OTM call options, you would receive Rs. 9,000 (Rs. 30 x 300).
• Purchase 1 lot of OTM put options of the stock, which in this case would be ASIANPAINT MAY 2400 PE. Assume that the premium for this call option is currently at Rs. 25 per share. So, to purchase 1 lot of OTM put options, you would have to pay Rs. 7,500 (Rs. 25 x 300).

Let’s apply the strategy and see how they work in three different scenarios.

Scenario 1: The share price falls down to Rs. 2,400 on expiry

When the share price falls down to Rs. 2,400, the status of your positions are likely to be as follows.

• Your stock position will go down by Rs. 100 per share (Rs. 2,500 - Rs. 2,400), which effectively translates to a loss of Rs. 30,000 (Rs. 100 x 300).
• Since the OTM call option strike price is higher than the spot price (Rs. 2,600 > Rs. 2,400), the buyer of the option would let the option expire worthless. And as a result, you would get to retain the Rs. 9,000 that you obtained from the sale of the OTM call option.
• However, the OTM put option that you bought would become at the money (ATM) due to the fall in the share price. As a result, the premium for the put option would also increase. Let’s say that it increases to around Rs. 125 per share and that you choose to square off your position. Now, your profit from this particular trade would amount to Rs. 30,000 [(Rs. 125 x 300) - Rs. 7,500].

The total net profit from all of the three positions ultimately comes up to Rs. 9,000 [Rs. 30,000 + Rs. 9,000 - Rs. 30,000].

Scenario 2: The share price rises up to Rs. 2,600 on expiry

On the other hand, if the share price rises to Rs. 2,600, the status of your positions are likely to be as follows.

• In this case, the OTM call option that you sold would become at the money (ATM) due to the rise in the share price. The buyer of the option chooses to exercise the option. So, you get to retain the Rs. 9,000 that you obtained from the sale of the OTM call option. And, you also get to sell your shares at Rs. 2,600 per share, which fetches you a total profit of Rs. 39,000 {[(Rs. 2,600 - Rs. 2,500) x 300] + Rs. 9,000}.
• Since you’ve purchased an OTM put option and the share price has gone up, it would expire worthless. As a result, you would have to forfeit the entire premium that you paid for the put option. This would lead to a loss of Rs. 7,500 [(Rs. 125 x 300) - Rs. 7,500].

The total net profit from all of the positions ultimately comes up to Rs. 31,500 [Rs. 30,000 - Rs. 7,500].

Scenario 3: The share price stays at Rs. 2,500 on expiry

Here’s where it gets tricky. If the share price doesn’t move anywhere during expiry, the status of your positions would be as follows.

• Since the price didn’t move anywhere, your stock position would end up in a no-profit, no-loss scenario.
• However, seeing as the OTM call option strike price is higher than the spot price (Rs. 2,600 > Rs. 2,400), the buyer of the option would let the option expire worthless. And as a result, you would get to retain the Rs. 9,000 that you obtained from the sale of the OTM call option.
• And the OTM put option that you purchased will expire worthless, which would lead to a loss of Rs. 7,500.

The total net profit that you get to enjoy from all of these positions will ultimately end up at Rs. 1,500 (Rs. 9,000 - Rs. 7,500).

Wrapping up

With this, we’re done with yet another chapter on options trading strategies. In the next one, we’re going to be looking at a slightly more complicated strategy that spans multiple expiries - calendar spreads.

A quick recap

• The collar strategy is also known as the hedge wrapper.
• It is generally used by traders to hedge short-term downside risks on a stock that they already own.
• In addition to limiting the losses, the collar options strategy also limits your profits. 
• The strategy is useful when traders feel that a particular stock has good long-term growth potential but suffers from high short-term downside risk. 
• To set up a collar trading strategy, you first need to own the shares of a company with an active derivatives segment.
• The next step is to sell an out of the money (OTM) call option contract of the stock.
• And finally, you need to buy an out of the money (OTM) put option contract of the same stock.
• When purchasing option contracts, always make sure that the lot size of the put options contract matches the total number of shares that you own.
• And in order for the collar to work, the expiration month for both the contracts needs to be the same.