What is a collar?

A collar is a type of options strategy that uses a combination of two different types of options strategies to limit your risk. There are two types of collars: costless and debit. With a costless collar, the investor pays no money but gives up some potential upside. With a debit collar, the investor pays a small amount of money but keeps all the potential upside.

To use the collar strategy, you need to already own at least 100 shares of stock. You also need to combine this position with a covered call above the stock price and a protective put below the stock price. This will limit your potential for making a profit, but it will also protect you from losing money if the stock price goes down.

You can execute the trade with put and call options of any expiration date and strike price, but the call and put sides must have the same expiration date. They must also correspond to the same number of contracts.

When executing this trade, it is important to be mindful that the price of a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. So if you want to enter a costless collar position, you generally need to enter the trade when there is a slight skew in strike prices relative to the underlying stock. This means that the strike price of the call option will be closer to the underlying stock than the strike price of the put option.

When to use a collar strategy

Collar strategies are appropriate for traders who already hold stock and want to limit their losses. The goal of the collar strategy is to use the credit from the short call to pay for the cost of the long put. This way, you have downside protection and also earn money if the stock price goes up. There are three different ways to enter this strategy: by credit, debit, or for free, depending on the width of the strike prices.

How to manage a collar position

The net effect of time decay on a collar strategy is a bit neutral. This means that the option you bought will lose some value, but so will the option you sold. If implied volatility increases after you set up the collar, the option you sold will become more valuable, but the option you bought will also become more valuable. 

In general, collar options are exercised only if they expire in-the-money. If you choose to not exercise the options at expiration, you can adjust the collar strategy during the trade. This means that if you are not ready to close out the long stock position, you can adjust the options contracts up or down, or roll them out to a later expiration date.

Collar maximum profit potential

The most you can earn from a collar is the sum total of any positive change in the current stock price minus the net debit paid, plus net credit received. 

Collar maximum loss potential

​​The most you can lose from a collar is the sum total of any negative change in the current stock price plus the net debit paid, minus net credit received.