How Does Collar Strategy Work in Different Scenarios?

Let’s take a look at how the strategy works with this position.
For the sake of our illustration and to make our calculations
easy let’s establish the collar using the December 27.5 put and
the December 30 call, with both trading at $1.00.

Remember our stock price was $28.50. The cost of the collar will
be $0 because you paid $1.00 for the put but you collected $1.00
from the sale of the call. How does the collar work in our usual
three scenarios: the “up” scenario, the “down” scenario and the
“stagnant” scenario?

In the “up” scenario, we find that when the stock rises, the
investor gains penny for penny until the stock reaches the call
strike. Once the stock reaches that level, the position no
longer gains because the stock is at the point where it will be
called away.

Capital gains of the position are maximized when the stock
reaches the call’s strike price. Let’s take a closer look at
what happens as the stock price goes up. With the stock at
$29.00, both the Dec. 30 calls and the Dec. 27.5 puts are out of
the money and thus worthless. Since there was no debit or credit
incurred in the options, the option profit (loss) is $0. Only
the stock position remains. The stock purchased at $28.50 is now
trading at $29.00 for a $.50 profit.

Let’s raise the stock price to $30.00. The puts and calls are
again worthless so your profit (loss) is solely determined by
the stock. The stock, which was purchased for $28.50 is now
worth $30.00 and represents a gain of $1.50. This $1.50 gain is
the maximum gain the position allows.

Once the stock goes over $30.00, the Dec. 30 call, which we are
short, would become in-the-money and therefore the stock
position would be called away at that price. When the stock
price rises to $31.00, the puts would be out-of-the-money thus
worthless but the calls would be worth $1.00.

You received no money for the establishment of the collar so you
would have a $1.00 loss in the options. Meanwhile, the stock
that you purchased at$ 28.50 is now worth $31.00 at expiration,
which is a $2.50 gain.

Combine the $2.50 gain in the stock with the $1.00 options loss;
you have a $1.50 profit again. You may do this calculation with
higher and higher stock prices but the outcome will always be
the same. This example shows how your upside potential is
limited.

Obviously, if the option portion of the collar incurred a debit
or credit, that inflow or outflow of money must be added to or
subtracted from the stock gain to get the overall return of the
position.

Normally, there will be a debit or credit incurred in the
collar. It is usually difficult to find a put and a call that
you want to use in the collar trading at an equal value. Let’s
use our last example with some minor price changes.

If the put had been trading at $1.25 instead of $1.00, then
there would be a $.25 capital outflow that would have to be
subtracted from the $1.50 gain to reduce it to only a $1.25
gain.

On the other hand, if the call was trading at $1.25 then you
would have collected an extra $ .25 which added to the $1.50
gain would produce a $1.75 gain. The cost of the collar always
impacts the bottom line profit or loss of the position.

Looking at the collar in the “stagnant” scenario, the stock
price would be unchanged thus neutral in terms of return.
Therefore, the potential profit or loss would come strictly from
the debit or credit of the two options.

If the stock does not move, as in our example, both the put and
call would finish out-of-the-money and be worthless.

Our profit or loss would simply be calculated from whether you
paid for the collar or collected from the collar and how much
that amount was.

Using the same prices as the previous example (the stock
purchase price of $28.00, the Dec. 27.5 put $1.00 and the Dec 30
call $1.00) we will now take a look at the “down” scenario.
Let’s set the stock price at $28.00 on expiration. At this price
both the Dec. 27.5 put and the Dec. 30 call are out-of-the money
and worthless. Since there is no credit or debit incurred in the
option position ($1.00 inflow from the calls, $1.00 outflow from
puts) the total return of the position is simply the gain or
loss from the stock.

With the stock purchase price of $28.50 and a stock price of
$28.00 on expiration, there will be a $ .50 loss in the
position. Setting the stock price at $27.50, we see that the
Dec. 27.50 puts and the Dec. 30 calls are again worthless and
with no debit or credit incurred, the positions profit or loss
will come down to the gain or loss on the stock.

With the purchase price of the stock being $28.50 and the stock
price at expiration $27.50, there will be a $1.00 loss. In this
case, we have reached the maximum loss. No matter how low the
stock goes, you can only incur a maximum loss of $1.00.

Now, let’s set the stock price at $26.00 and see if this holds
true. With the stock at $26.00 on expiration, the Dec. 30 calls
are out-of-the-money and worthless. The Dec. 27.5 puts, however,
are in-the-money and now worth $1.50.

The stock you purchased for $28.50 is now worth $26.00 on
expiration which is a $2.50 loss. Combining the $2.50 stock loss
with the $1.50 gain in the puts and you have a $1.00 loss in the
overall position.

This demonstrates that $1.00 is the maximum loss of the
position. Keep in mind that if the stock position creates a
debit or a credit, it must be added to, or subtracted from the
stock loss.

Most of the time, there will be a small debit or credit incurred
in the option position. It is relatively infrequent that the put
and call used in the collar are trading at the exact same price.

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