When to use: Collar Option Strategy is used when the investor writes a covered call to earn a premium but wants to protect himself from an unexpected sharp fall in the price of the underlying securities. In this strategy, your risk from a downside in the stock price is protected by purchasing a put option.
How it works: In collar option strategy, you buy the underlying share; sell/write 1 out-of-the-money call option and buy 1 out-of-the-money put option, each with the same expiry date, T.
For example: On 20th August 2013, when the share of Sesa Sterlite Limited was trading at Rs. 150.00, you decided to buy the share at the current price; sell/write 1 out-of-the-money call option at a premium of Rs. 18.50, with a strike price of Rs. 160.00 expiring 26th September 2013; bought 1 out-of-the-money put option at a premium of Rs. 2.85, with a strike price of Rs. 140.00.
For Call Option: If the price of Sesa Sterlite Limited rises above Rs. 160.00 (i.e. strike price), the buyer of the option can exercise his option, but the price of the stock must rise above Rs. 178.50 (i.e. the strike price + the amount of premium received) for the option buyer to exercise the option and make profit from the same. In other words, so long as the price stays below Rs. 178.50, you will be making some profit in the form of option premium. In such a case, the put option will not be exercised.
For Put Option: If the price of the share stays below Rs. 140.00 (i.e. the strike price) until expiry, you can exercise your option, but the price of the stock must fall below Rs. 137.15 (i.e. the strike price – the premium), for you to exercise your option and make a profit. In such a case call option will not be exercised by the buyer of the call option.
Risk/Reward: Unlike, a Covered call, the downside risk in the collar option strategy is also limited and the reward/profit is also limited.
The table below shows the net payoff of collar option strategy at different spot prices:
How to use the Collar Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Collar Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Sesa Sterlite Limited option contract is for 2,000 shares. Accordingly the net premium received will be Rs. 31,300 for 2 lots (i.e. 15.65*2,000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 49,568 (i.e. Strike price * Lot size * 15.49%) for selling/writing a single lot of Sesa Sterlite Limited call option. Note that the total value of your outstanding position in this case will be Rs. 3,20,000 (i.e. strike price * lot size).