You can think of a collar as simultaneously running a protective put and a covered call. Some investors think this is a sexy trade because the covered call helps to pay for the protective put. So you've limited the downside on the stock for less than it would cost to buy a put alone, but there's a tradeoff.
The call you sell caps the upside. If the stock has exceeded strike B by expiration, it will most likely be called away. So you must be willing to sell it at that price.
Buying the put gives you the right to sell the stock at strike price A. Because you've also sold the call, you'll be obligated to sell the stock at strike price B if the option is assigned.
Maximum Potential Profit
From the point the collar is established, potential profit is limited to strike B minus current stock price minus the net debit paid, or plus net credit received.
Maximum Potential Loss
From the point the collar is established, risk is limited to the current stock price minus strike A plus the net debit paid, or minus the net credit received.
Break-even at Expiration
From the point the collar is established, there are two break-even points:
- If established for a net credit, the break-even is current stock price minus net credit received.
- If established for a net debit, the break-even is current stock price plus the net debit paid.
Ally Invest Margin Requirements
Because you own the stock, the call you sold is considered covered. So no additional margin is required after the trade is established.
As Time Goes By
For this strategy, the net effect of time decay is somewhat neutral. It will erode the value of the option you bought (bad) but it will also erode the value of the option you sold (good).
After the strategy is established, the net effect of an increase in implied volatility is somewhat neutral. The option you sold will increase in value (bad), but it will also increase the value of the option you bought (good).
Many investors will run a collar when they've seen a nice run-up on the stock price, and they want to protect their unrealized profits against a downturn.
Some investors will try to sell the call with enough premium to pay for the put entirely. If established for net-zero cost, it is often referred to as a zero-cost collar. It may even be established for a net credit, if the call with strike price B is worth more than the put with strike price A.
Some investors will establish this strategy in a single trade. For every 100 shares they buy, they'll sell one out-of-the-money call contract and buy one out-of-the-money put contract. This limits your downside risk instantly, but of course, it also limits your upside.