The Tradeoffs
While it’s tempting to think of the Collar as a way to get “free” Put protection, there are some tradeoffs. By selling Calls, we are limiting our upside. In the example above, we could have a $10 gain to the upside. We’d also get to keep any net premiums collected, another $0.25 per share. But because we’re obligated to provide shares at $170, we have capped our profit potential.
The Collar also only gives us partial protection to the downside. Options also have a limited life and expire.
What Happens at Expiration?
If the share price is above our Call strike price at expiration, we’re likely to have our shares “called away” – meaning we’ll be obligated to sell our shares at the strike price, $170 in this example.
But we could also extend the duration by rolling that Call out for additional credit. As long as there are more than a few cents of time value in our short Call, we’re less likely to have it exercised even if it is in-the-money (ITM). If our counterparty wanted to close their position, as long as there’s time value left in the option, they would be better off to sell their long Call rather than exercise it against us.
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If the share price is between our Call and Put strike prices at expiration, those options expire worthlessly, and we’re left with our stock as before.
If the share price has dropped below our Put strike, we would want to either sell the Put or exercise it. We could “put” the stock to our counterparty at $140 per share. Alternately, we could sell the Put and continue to hold onto our shares.
The best case is for the options to expire with the share price just below the Call strike price. In that case, both the Puts and the Calls expire worthlessly, and we get to keep our shares. We are then free to sell shares at a profit or keep them and apply another Collar further out in time.
Summary
If you own shares that you don’t want to sell, consider putting on a Collar using options to give you some downside protection. A Collar entails selling calls against your shares and using the premium collected to purchase puts for downside protection. The tradeoff is your upside is limited. But you get to hold onto your shares to continue to collect dividends (if any), all while having long Puts in place for downside protection.
Read On To Learn More About Options Trading
Every day on Options Trading Signals, we do defined risk trades that protect us from black swan events 24/7. Many may think that is what stop losses are for. Well, remember the markets are only open about 1/3 of the hours in a day. Therefore, a stop loss only protects you for 1/3 of each day. Stocks can gap up or down. With options, you are always protected because we do defined risk in a spread. We cover with multiple legs, which are always on once you own.
If you are new to trading or have been trading stock but are interested in options, you can find more information at The Technical Traders – Options Trading Signals Service. The head Options Trading Specialist Brian Benson, who has been trading options for almost 20 years, sends out real live trade alerts on actual trades, such as TSLA and NVDA, with real money. Ready to subscribe, click here: TheTechnicalTraders.com.
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