With a collar strategy, the manager typically has a long underlying position in a portfolio of stocks. The manager seeks to protect against downside risk by purchasing an out-of-the-money put option. While it is certainly prudent to protect against downside risk, put options obviously cost money.
To help offset the cost of the put options, a collar strategy seeks to generate income by writing out-of-the-money calls against their market position. In effect, this caps the upside potential of a collar. This is the fundamental trade-off of a collar strategy: downside protection is purchased in exchange for selling away some of the upside potential.
A collar typically has three components:
- A long, buy-and-hold position in a market
- Long, out-of-the-money puts to protect on the downside
- Short, out-of-the-money calls to help pay for the puts
Below is a graph outlining the return profile of a covered call strategy.
A “Protected” Covered Call
If the above chart looks a bit familiar, it should. The collar strategy is closely related to the covered call. In fact, two of the three legs of the collar are the same as the covered call: the long equity position and the short call position.
With the covered call strategy, we stated that one of the drawbacks is there is no downside protection. One way of thinking of collars is that they are essentially “protected” covered calls: using the premium they generate from the short calls not for income but to purchase downside protection.