What Is a Protective Collar?

By Markets Fool.com

There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

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A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

Here's how a protective collar works.

The basic setup

A protective collar is a strategy where you own the underlying stock, and subsequently sell a covered call while simultaneously buying a protective put (also known as a married put). What this does is effectively limit both your upside and downside associated with the stock price in the short term, since the position is a combination of selling a short call while buying a long put.

Furthermore, the strategy can be implemented at little to no cost, since the premium received from the short call can offset the cost of the long put. It's called a collar since you are limiting the risk exposure to a narrowly defined range within the strike prices.

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For example, if you purchase a stock at $50, you could sell a $55 call while buying a $45 put. Let's say that the call and put are both trading at $1.50 (both should have comparable pricing due to put/call parity). This would allow the collar to be implemented at $0 cost (not including commissions).

Maximum loss: difference between stock price and put strike price

The most that you can lose on a protective collar is the difference between the stock's current price and the put strike price. Since the long put provides downside protection in the event that the stock price declines below the strike price, you are protected from any downside below that strike price.

In this example, if you bought the stock at $50 and exercised the $45 put, you would lose $5. This would occur if the stock price closes upon expiration at any price less than or equal to $45.

Maximum gain: difference between stock price and call strike price

The most that you can make on a protective collar is the difference between the stock's current price and the call strike price. Since the short call requires that you sell the stock and deliver shares in the event that the stock price increases above the strike price, your upside potential is also limited to that strike price.

In this example, if you bought the stock at $50 and were required to deliver shares at $55 to satisfy the short call's exercise, you would gain $5. This would occur if the stock price closes upon expiration at any price greater than or equal to $55.

Breakeven: stock price plus or minus net premium paid

The breakeven for a protective collar would be equal to the stock price plus or minus any premium paid or received.

In this example, there is no applicable breakeven point since the net cost of the position was $0.

Your mileage may vary

These calculations for max gain, max loss, and breakeven become more complicated if you are not establishing the stock position at the same time.

For instance, if you've held the stock for an extended period of time and have a very low cost basis on the stock, then the max gain, max loss, and breakeven points will differ.The net premium paid or received will also depend upon the strike prices chosen. Only if the strike prices are equidistant from the current stock price would premium paid be expected to fully offset by premium received. In other scenarios, there is likely to be either a small net debit or net credit associated with the trade.

The article What Is a Protective Collar? originally appeared on Fool.com.

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