Intermediate to advanced options strategy knowledge

Views 12K Aug 13, 2024

Long Collar

If you hold a stock and anticipate a market pullback, buying a put option (aka. protective put) can help hedge against downside risk. But setting up this strategy can be expensive. A more cost-effective approach is the long collar strategy.


I. Strategy Explained

1) Setup

Owning the stock + "Buy Put A" + "Sell Call B"

The collar strategy involves owning or buying at least 100 shares of stock, then buying a put and selling a call with the same expiration simultaneously.

It's just like adding a covered call to a protective put, which may offer some downside protection while generate additional income. Keep in mind that if the stock price rises instead, the upside is limited to the strike price of the covered call.

Note: Typically, one U.S. stock option corresponds to 100 shares of the underlying stock. If you hold 200 shares of the underlying stock, you should buy two put options and sell two call options.
Note: Typically, one U.S. stock option corresponds to 100 shares of the underlying stock. If you hold 200 shares of the underlying stock, you should buy two put options and sell two call options.

2) Breakdown

The potential profit from a long collar comes from the stock's appreciation. Based on the strike price of options (for example, buy an out-of-the-money put and sell a close-to-the-money call), you may also gain a net premium.

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3) Features of Strategy

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Ideal Conditions: Low to medium volatility, neutral to slightly bullish the underlying.

Capped Profit: A long collar has a capped profit. If the stock price rises above the call strike price, you may be required to sell your shares, which limits potential gains from further price increases.

Limited Loss: With a long collar, losses are limited. If the stock price falls below the strike price of put, you can exercrise the put option and sell your shares. This limits the losses that would incur from a further decline in the stock.

Lower Initial Cost: The cost of opening the options position can be negative, zero or positive, depending on the relative cost of buying Put A and selling Call B.  The premium received for the sale of Call B can offset at least part of the cost of Put A.


II. Case Study

Assume TUTU is a established public company believed to have promising long-term prospects. You aim to profit if TUTU's stock price rises or stays flat, while also protecting yourself against a significant drop in the stock price.

Therefore, you set up a long collar strategy. While holding 100 shares of TUTU stock priced at $50 each, you sell a call option and buy a put option.

You can tolerate the stock price dropping to $48, so you buy a put option with a strike price of $48. Simultaneously, you're willing to sell the stock at $60, so you sell a call option with a strike price of $60.

If the stock price falls, the put option helps protect your position and limits your loss. If the stock price rises, you can sell the stock at your desired price but won't benefit from any further gains past the call option strike price.

Note: TUTU: A theoretical stock for demonstration purposes only.
Note: TUTU: A theoretical stock for demonstration purposes only.

Cost of purchasing TUTU stock: $5,000 ($50 per share).

Premium received from the call option: +$200 (+$2 per share).

Premium paid for the put option: -$400 (-$4 per share).

Net premium to open this strategy: +$200 -$400=-$200 (-$2 per share).

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Scenario 1: Stock Price < Put Strike

In this situation, the call option is out-of-the-money, and the put option is in-the-money.

As the buyer of the put option, you can exercise the put and sell the 100 shares of TUTU stock you hold at the strike price of $48.

Max Loss: $(48-50-2)*100*1=-$400

Thanks to the put option, even if the stock price falls to $0, you can limit your loss to $400.

In this scenario, the $200 income from selling the call option offsets part of the cost of buying the put option, making this approach more cost-effective than the protective put strategy.

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Scenario 2: Put Strike < Stock Price < Call Strike

In this situation, both the put and call options are out-of-the-money at expiration and will expire worthless.

This is similar to just holding TUTU stock, with returns fluctuating based on the stock price. However, due to the initial $2 per share premium paid, the return will be $200 less than if you had only held the stock.

Breakeven: $50+$2=$52.

If the stock price remains $50, your return will be: $(50-50)*100-200=-$200

If the stock price rises to $56, your return will be: $(56-50)*100-200=$400


Scenario 3: Stock Price > Call Strike

In this situation, the put option is out-of-the-money, and the call option is in-the-money.

You are likely assigned to sell the 100 shares of TUTU stock with a strike of $60.

Max Profit: (60-50-2)*100=$800

Since the option has been exercised, any further increase in the stock price is irrelevant to the option seller.

The premium cost is -$200, and the income from selling the stock is $1000. Therefore, when the stock price is $60 or higher, the strategy reaches its maximum profit of $800.


III. How to construct a long collar on futubull

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Scenario 1: Without the underlying stock.

Access: Go to Options > Chain > Tap on the Strategy tab at the bottom of the screen > Select Collar

The system will then automatically help you buy 100 shares of the underlying stock, buy one put option and sell one call option, forming a long collar.

Scenario 2: Already owned the underlying stock.

Access: Go to Options > Chain > Tap on the Strategy tab at the bottom of the screen > Select Single Options and directly buy a put option and sell a call option.

The system will automatically recognize and construct a long collar for you.


IV. Applying the long collar strategy

Investors typically use a long collar for three main purposes:

1) Hedging downside risk

Have a long-term positive outlook on the underlying stock but be concerned about a short-term market decline and wish to hedge the risk.

By constructing a low-cost long collar strategy, you can help protect your stock holdings from significant loss while retaining the potential for long-term gains in the stock if the shares are not called away.

2) Reducing premium costs

If you have already constructed a protective put strategy but feel that the cost of opening the position is too high, you can add a "sell call" leg to collect the premium. Some stock options can be quite expensive, so using a long collar can help save on setup costs.

3) Adding protection

If you have a covered call strategy but the risk of the stock falling has increased beyond your expectations, you can buy a put option in the underlying stock to better protect the stock from significant loss.


V. FAQs

Q: Choosing the expiration date?

A: This strategy involves both buying a put and selling a call. However, the core purpose of the strategy remains to provide protection for stocks that you are bullish on in the long term. Therefore, choosing the appropriate expiration date should be based on the forecast of the duration of somewhat bearish near-term sentiment.

General market experience suggests:

If you expect any stock price decline to be limited to the near-term: you can choose a shorter expiration date.

If you expect the stock price to remain volatile in the long term: you can choose a longer expiration date.


Q: Choosing strike price?

A: In practice, when constructing the strategy, you can adjust the strike width between the call and put options to align with your strategy logic and expectations.

While the long collar strategy may still incur losses, you can adjust the strike prices based on your risk tolerance.

General market experience has been shown to support:

Selling Call: a strike price close to the price at which you are willing to sell the stock. This means that if the stock price rises to this level, you are comfortable selling the stock at this price.

Buying Put: a strike price within the range of the maximum acceptable loss you are willing to incur before exiting your position in the underlying stock. By doing so, if the stock price falls, your theoretical maximum loss will be limited.

Investors sometimes try to construct a long collar strategy at zero net debit or for net credit. You can adjust the strike prices based on your strategy cost budget.

General market experience suggests:

If you aim to establish a zero-cost strategy, you typically choose out-of-the-money (OTM) calls and puts. You can set the call strike price closer to the current stock price than the put strike price. By doing so, the premium received from selling the call may be sufficient to offset the cost of buying the put.


Q: Methods and considerations for exiting a long collar strategy?

A: If the stock price drops below the put strike price, the put becomes in-the-money and the call expires worthless:

Exercising the Put:

As the put buyer, you can sell the stock at the strike price.

In this scenario, you no longer hold the stock. If you still have a long-term bullish view and expect a short-term decline, you can repurchase more shares at a lower market price and establish a new put position to continue hedging protection from long collar.

Not Exercising the Put:

If you decide not to exercise the put, you can either close the put position or roll the position.

Closing the long put position: By closing the put option, you can realize the profit or loss.

Rolling the position: Close the position and open a new position to adjust the strike prices or expiration dates of the call and put options to better align with the current market conditions and expectations.

Q: If the stock price rises above the call strike price, the call becomes in-the-money and the put expires worthless:

Exercising the Call:

If the call option buyer exercises the call, you will be assigned to sell the stock at the strike price.

In this scenario, you no longer hold the stock. If you wish to re-enter the market, the cost of buying back the stock may be higher. Therefore, it's crucial that the expiration date of this strategy aligns with your expected bearish cycle.

Avoiding Call Exercise:

If you do not want the call option buyer to exercise the call, you can buy back the call option to close the position early or roll the position.

Closing the short call position: By buying back the call option, you might incur some losses, but you retain ownership of the stock.

Rolling the Position: Close the position to realize your loss or gain and open a new position to adjust the strike prices or expiration dates of the call and put options to better align with the current market conditions and your expectations.

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Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.

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