The Collar Option Strategy - An In-Depth Guide [+ Examples]
![The Collar Option Strategy - An In-Depth Guide [+ Examples]](/content/images/size/w1200/wordpress/2022/01/Collar-Option-Strategy.jpg)
The collar option strategy is a popular option trading technique that also happens to be one of the most complicated. It is a three-legged strategy that has a buy to open, a sell to close, and an offsetting order. The idea behind this strategy is to either take advantage of opportunities or hedge against risk. In this article, we will teach you everything you need to know about the collar options strategy for those interested in learning more.
What is a collar option strategy?
The collar option trading technique is a three-legged strategy that has a buy to open, a sell to close, and an offsetting order. The idea behind the collar strategy is to either take advantage of opportunities or hedge against risk.
For example, if you are bullish on the price of ITC stocks, but want to limit your exposure in case they go down, then you can use the collar option trading technique to protect your portfolio. You would purchase 3200 shares (1 Lot in the future) of that stock at ₹250 per share, you would also buy 3200 quantities( 1 lot) of250 Put option and sell 3200 quantities (1 lot) of 270 Call Option.
This creates a “long collar option strategy”. The long position will profit from increased prices while the short positions will profit from decreased prices. If ITC stock maintains their current value or increase in value, then you have locked in your profits by closing out your positions with no losses.
Although this strategy provides good protection it also limits profits as well as increases risk. For example, if ITC stocks increase in value to a certain limit instead of maintaining their current value then you are not able to profit from it because the short positions protect against this risk. So before using this strategy consider whether or not it suits your needs given the desired return, time horizon, and level of risk tolerance for investment capital involved.
Collar option strategy explained
The collar strategy involves using three different orders to balance the risk of one trade. There is the buy to open, the sell to close, and an offsetting order. The idea behind this strategy is to either take advantage of opportunities or hedge against risk.
The mechanics behind the strategy are that you open a trade with a long or short position and then sell that position at a predetermined price before taking any profits. This will limit your exposure by creating an area of protection on each side of your trade.
The principles of this technique include:
- Creating protection on both sides of the market
- A middle ground between risking all your capital or limiting your potential gain
- Achieving limited risk with unlimited profit potential
- Assuring that you have money available on each side of your trade.
There are two types of collar option strategies:
- Long collar option strategy
- Short collar option strategy
Long collar options strategy
As the name suggests long collar option strategy is a bullish strategy and it should initiate when you are expecting the price to go up only. The formation of this strategy is:
- Long stock/future
- Long ATM/ITM Put strike
- Short OTM Call strike.
Here all the legs are with the same lot size and same expiry. Look at the below Pic for its payoff chart.
Short collar options strategy
It’s a bearish strategy and should only initiate when you are expecting the price to go down. The formation of this strategy is:
- Short stock/future
- Long ATM/ITM Call strike
- Short OTM Put strike.
Here all the legs are with the same lot size and same expiry. Look at the below Pic for its payoff chart.
If you look at the above payoff graphs, you can easily understand that both are directional strategies and work well in the directional market only.
Collar option vs call spread
Collar option strategy and a call spread both have the same behaviour toward the directional movement but in collar option strategy, you can reduce the risk and increase your return. To understand it, let us look at the below two strategies:
1- Bull Call Spread strategy:
2- Long Collar Strategy:
Now, If you look at both the strategies, you can see that view is the same i.e. Bullish for both the strategies. Breakevens are also the same plus I choose the same strikes also.
But look at the risk and reward. Both are good in Collar strategy compared to call spread. So Collar gives you a better risk: reward compare to other debit spread strategies.
When to use collar option strategy?
The collar option strategy is a versatile strategy that can be used in different situations. There are many different reasons why this strategy may work for you.
One example of when the collar option strategy would work for you is if you want to hedge against risk. In other words, if you want protection from a possible downside move in one direction. This may be the case if your stock prices have been trending down and you don’t want to lose any more money on those stocks.
Another example of when the collar option would work for you is if your stock prices have been trending up and you’re looking to lock in profits before they go back down again.
The collar option strategy may also work for you if you want to take advantage of opportunities but just can’t decide which way the market will swing at any given time. You may use the collar option if there are two options available with different strike prices and expiration dates which present different opportunities.
The worst-case scenario with this strategy is that it will cost some money, but not as much as it would without hedging or profiting from opportunities.
How to trade collar strategy?
As you know the collar option strategy is a directional strategy. You can create either a long-collar option strategy or a short-collar option strategy.
To effectively implement the collar options strategy, it is important to be able to analyze Directional opportunities. When examining opportunities with the collar option strategy, it is best to look at the potential upside or downside.
There are four forms of directional opportunities:
- The current price is giving a breakout from its previous strong resistance zone. (Bullish)
- The current price is giving a breakdown from its previous strong support zone. (Bearish)
- The current price is giving a false breakdown and you find a short-covering opportunity. (Bullish)
- The current price is giving a false breakout and you find a long unwinding opportunity. (Bearish)
Your goal with this strategy should be to take advantage of these opportunities when you can. You may prefer one type of opportunity over another.
For example, if you only want to take advantage of upside trades, you may want to consider a Long collar option strategy instead.
If you only want to trade against downside movement, then you may want to explore a short-collar option strategy. It’s important that you decide which situation suits your needs best before implementing any strategy in order for it to be successful.
Best collar option strategies
The success of this strategy depends upon how accurate you are in capturing directional trends. That’s the reason I prefer that you should optimize these strategies based on your experience and risk appetite.
I have optimized this strategy in such a way that if we are wrong then the loss should be very low. If you want to learn how I’m choosing strikes for the collar option strategy then you can join our Option Strategies: A Mentorship program.
In this program, I’m teaching you how you can initiate option strategies in a better way to generate your monthly cheque with limited risk. Whether you are a beginner or an advanced trader you can join this program to enhance your trading skills.
Collar options strategy adjustment
Adjust are simple for this strategy. Let’s say you have created a long collar strategy and now your stock is moving down, then you can book profit in sold call and bring it down just one strike above the bought Put strike.
The same you can do is the short collar option strategy. You can shift your short Put to higher-level If there is any upside movement in your stock.
The pros and cons of the collar strategy
The collar strategy is a great way to hedge against risk or take advantage of opportunities. It does take some knowledge and experience so it’s not the best option for someone who is just starting out in the market.
If you’re looking for a strategy that will help you mitigate losses, then this may be an appropriate choice. However, if you’re hoping to make gains from the time decay then this is not really the best strategy.
It can also be difficult for those who don’t have a lot of experience in trading because it takes knowledge and skill to predict which direction prices will go and put on your trades accordingly. If you are still interested in learning more about how the collar options strategy works, below we will break down all the pros and cons.
Pros: Collar Options Strategy is an advanced options strategy that requires less risk than other types of options strategies such as vertical spreads or iron condors. This means that when your trade does not work out well, there’s less chance you’ll lose money with this type of strategy than others.
Conclusion
In this article, we explored the collar option strategy. The collar strategy is a technique that is designed to be used as a hedge against the downside risk of a position. The collar strategy can be used as a hedge against the downside risk of stock positions.
If you have any queries or questions related to this strategy, feel free to post in the comment box. You can follow me on other social media networks to get free strategies and updates.
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DISCLAIMER: – we are not a SEBI research analyst. Views posted here only for educational purposes. There is no liability whatsoever for any loss arising from the use of this product or its contents. This product is not a recommendation to buy or sell, but rather a guideline to interpreting specified analysis methods. This information should only be used by investors and traders who are aware of the risk inherent in securities trading.
