Collar Option Strategy: Limiting Your Risk While Staying Bullish
A collar option strategy is used to limit the returns of an underlying long position to a specific range. Typically investors use the option collar to hedge an underlying long position against downside volatility, and at the same time guarantee an exit if the market goes higher.
This is achieved by buying a protective put option and simultaneously selling a covered call to finance the cost of the put.
One way to think of the collar options strategy is it works the same way as placing both a stop-loss and a take-profit order against the underlying asset. By using the strategy, investors limit both the potential upside and potential downside associated with holding the underlying asset.
The first step in the collar option strategy is selecting which strike prices align with your market view.
Let's assume an investor holds 1.0 BTC, which is currently trading at $20,000 and wants to hedge against a drop below $18,000 in the next two months. They may do something like this:
Buy 1.0 BTC $18,000 put option with 60 days-to-expiration (DTE) — the buyer pays a premium of $1,000.
To offset the cost of the put, the investor then sells a covered call option. The call option is usually, although not always, for the same amount of underlying, and with the same expiration date.
The investor sells 1.0 BTC $22,000 call option with 60 DTE — receiving a premium of $1,000.
Here, the cost of the trade is zero ($1,000 premium paid -$1000 premium received). Depending on market conditions and the selected strikes, a collar option may be traded at zero cost (zero cost collar), a net credit (premium received > premium paid), or a net debit (premium received < premium paid).
The cost of the strategy varies depending on the distance of the strike prices to the underlying asset. Typically, a collar position involves strikes of equal distance to the underlying asset. Here, the premiums should hold equal, or close to equal value (delta-neutral).
Delta is the calculation used to determine how much an option premium changes in value for each $1.00 move in the underlying asset. Call options have a positive delta, ranging from 0 to 1, and puts have a negative delta ranging from -1 to 0.
At-the-money options typically have deltas of 0.5/-05, reflecting the equal odds of expiring either in or out-of-the-money.
Call delta increases as the market moves higher, and put delta increases as the price moves lower.
Understanding delta helps to explain the mechanics of the options collar.
If the underlying asset falls, the value of the long put increases at an ever-faster rate, helping to offset the loss in the underlying. If at expiration, the underlying asset is below the strike price, the put delta is -1.0, meaning the value of the put increases at the same rate the underlying falls. Here, the put perfectly hedges the difference between the strike price and the option settlement price.
By contrast, if the underlying moves higher towards the call option's strike price, the premium of the short call increases. Similarly, if at expiry, the underlying asset is above the strike price, the option delta is 1.0. Here, the losses incurred from the short put will offset the underlying’s gains 1:1 above the strike price.
The key difference is that for the short out-of-the-money call to expire in-the-money the underlying will be higher than when the trade was initiated.
Collar Option Strategy: How it Works
The collar option strategy combines the protective put and the covered call strategy. As such, it can be used as an alternative to both.
Combining the two strategies has benefits and limitations. To understand the potential payout and risk of a particular options strategy, option traders use payoff diagrams.
The below payoff diagram represents a long position in an underlying asset, like a stock or BTC. The black line is the price moving higher (left to right), and the blue line shows the profit and loss as the market moves away from the purchase price (A).
Here, there are three outcomes:
The market has no movement and the asset value remains the same.
The position makes money when the market moves higher.
The underlying asset loses money when the market falls.
Long Underlying Asset Payoff Diagram
Option Collar vs Covered calls
The main advantage of using the options collar as opposed to a covered call strategy, is the collar's protective put hedges against a drop in the underlying.
The below payoff diagram shows that when used in isolation, the covered call has limited potential profit, and a significant downside (premium received - the difference between the underlying asset price and $0).
Covered Call Payoff Diagram
Whereas, the collar strategy limits the maximum potential loss.
Collar Strategy payoff diagram
Option Collar vs Protective Put
Adding the covered call to the protective put helps cover the cost of the out option. However, it also caps the upside profit potential if the short call expires in-the-money (ITM).
An option is consideredin-the-money if the underlying price is above the strike price (calls), or below the strike price (puts). Here, there is an immediate benefit in exercising the options.
Any strike price in an unprofitable position relative to the underlying is referred to as Out-of-The-Money (OTM). For puts, this is a strike price below the current market price. For calls, it's any strike price above the current market price. Lastly, a strike price equal to the underlying asset price is called At-The-Money (ATM).
The long put, when used alone, protects against potential downside without limiting the potential profit— the maximum loss is limited to the purchase price of the option.
Long Put Payoff Diagram
Who is the Collar Option Strategy For?
The collar is a simple option strategy with limited risk, and thus suitable for investors of all knowledge levels. However, to get the best from this play, it's advisable to select the strike prices that match your investment objectives.
Reverse Collar Option Strategy
As the name suggests, the reverse collar option involves doing the opposite of the traditional collar strategy.
The reverse collar is used to limit an underlying short position to a specific trading range. Instead of writing covered calls and buying puts, an investor with a short position sells covered puts and buys protective calls.
Here, the long call hedges the short position, and the short put limits the maximum profit potential.
The reverse collar is widely used in commodity markets, where its referred to as a "producer hedge". Commodity producers use the strategy to lock in both the best-case and worst-case price levels to exit their underlying short position (future production).
When to Use the Collar Option Strategy
Because the covered call works against the underlying asset in a rising market, the collar option is best deployed when an investor is worried about near-term weakness.
The advantage of using a collar option as opposed to placing a stop and limit order against the underlying is its versatility.
With the collar strategy, the underlying asset could trade below the long put strike price whilst the contract is active but turns higher before the expiration date. Here, the protective put works perfectly, allowing the investor to weather near-term volatility but crucially keep their long-term long underlying position.
Assuming the cost of entering the trade is zero (premium paid = premium received), the breakeven point at expiration is the same price as when the trade was entered.
Because the corresponding premiums offset each other, the underlying price determines the breakeven point. If the cost of the strategy is a net debit, the underlying asset must rise equal to that amount to offset the cost. Whereas for a net credit, the breakeven point is the price at which the underlying falls equal to the received credit.
The sweet spot for the collar option is when the underlying asset settles equal to the short call strike. Here, the short call is at-the-money and expires worthless and the investor keeps the gains generated from the underlying asset's price appreciation.
Adjustments to Make in Bearish Markets
Because options are flexible, investors can adjust their position to reflect a changing view of the market. However, doing so can impact the max profit and loss potential.
Because the option collar offers downside protection, investors are unlikely to make adjustments in bearish markets. Instead, let's examine ways to adjust for bullish price action:
Mildly Bullish, medium risk — if the market moves lower towards, or below the put strike, and the investor believes the price will soon turn higher, they can sell a further out-of-the-money put option to generate an extra premium. Doing this transforms the standalone protective put into a bull put spread. Although this play generates additional income, it also limits the hedge to the difference between the higher and lower strike.
Bullish, low risk — either close both the put and call or buy back only the short call, leaving the protective put open. Whilst this increases the overall cost, it changes the strategy to low risk with unlimited upside.
Bullish, high risk — selling a put option at the same strike price as the short call effectively creates a synthetic long position. Because the short put will be deep in-the-money it generates a hefty premium. Furthermore, due to put/call parity, should the market rise, the short put will lose value at the same rate as the short call, effectively doubling the exposure to the underlying asset.
Maximum Take Profit Potential
The maximum take profit potential is the same as the sweet spot. If the underlying asset is equal to the short call strike price at expiry, the call option expires worthless, and the investor profits from the underlying's appreciation.
Maximum Incurred Loss Potential
The maximum incurred loss potential when using the collar strategy is if the underlying asset is below the long put strike price at the expiration date. Here, the maximum loss is the difference between the price of the underlying asset at the time of trade and the strike price of the put option (+/- the net cost of the trade).
Collar Option Strategy Example
The below example shows how an investor holding an underlying long stock position in Amazon (NYSE: AMZN) totaling 100 shares could use a collar option to protect against potential price volatility in the underlying security surrounding an approaching earnings call:
Underlying Amazon stock price of $135.00
The investor purchases 1 contract (100 shares) of the Amazon $125.00 put option — paying a premium of $12.00 per share ($1,200)
The investor then sells 1 contract (100 shares) of the Amazon $145.00 call option with the same expiration month — receiving a premium of $11.50 ($1,150)
The cost of the trade is a net debit of $50.00 (premium received - premium paid x option multiplier of 100 shares).
Here, the investor's downside risk is protected if the underlying stock price falls below $125.00, with a guaranteed sale price of $145.00 if the short call option expires in-the-money.
With just a few simple steps, crypto traders can use Bybit's USDC-settled options to deploy the collar strategy to protect the underlying crypto holdings.
Log into your Bybit trading account and under Derivatives select USDC Options.
Select the desired expiration date, or view all the available expiration dates at the same time.
Select the strike price you wish to trade. Call options are shown on the left-hand side of the option chain and puts on the right.
With the strike now selected, an order placement ticket appears. Here you will find the Greek calculations, the recent trades, and the market depth.
By scrolling down, you can view the payoff diagram for the selected option.
The margin requirement is calculated and displayed at the bottom of the order ticket once you have chosen your order size and direction (buy or sell).
Click Place Order if you want to continue.
Repeat the process for the remaining strike (either put or call) to complete the options collar strategy.
Collar Option Strategy Tips
Select strike prices that reflect your view on the underlying asset price.
Choose option contracts with expiration dates that fit your objectives.
Remember to factor the cost of the strategy (either net credit or net debit) into the breakeven price calculation.
Accounts with minimum net equity of 1,000 USDC can take advantage of lower margin requirements and higher leverage by signing up for Portfolio Margin mode.
The portfolio margin mode uses a risk-based margin policy designed to reduce margin requirements for hedged portfolios. It does this by offsetting the exposure of long and short options positions against each other.
Because the underlying asset in the collar option hedges the option strikes, Portfolio Margin mode reduces the margin requirements for this strategy significantly.
Theta Decay Impact
Theta decay (or time decay) has minimal effect on this strategy. Both the put and the call premiums will erode over time due to the effects of time-decay.
Although an option's sensitivity to time-decay changes depending on how close it is to the underlying, the time value of both options is zero at the expiration date. Here the time value lost on the long put is offset by the gain in the short call.
Implied Volatility Effect
Implied volatility (IV) has a limited overall effect on the collar option strategy. All things being equal, option premiums rise when IV increases. In this strategy, a linear expansion in IV is offset by the opposing long and short positions.
However, one thing to consider is that the more volatile the market is, the greater chance one of the strikes with expire in-the-money.
Protects against near-term weakness
Max loss and max profit are known at inception
The strategy has limited profit potential
It caps the upside of the underlying asset
The biggest risk when using the options collar is missed opportunity. This particular strategy is unfavorable if the underlying asset moves much higher. Here, alternative strategies would be more effective.
Investors usually deploy the option collar when unsure of the underlying's near-term direction. However, alternative strategies can offer similar downside protection profit with greater upside potential :
Long Strangle — Buy an ATM put and an ATM call with the same expiration dates.
Bull Put Spread — Buy an ATM, or OTM put and sell a further OTM put.
Protective Put — Buy a standalone put option.
The option collar strategy is a great way to hedge a long-term holding. Although selling the call limits the upside profit potential, the protective put reduces the downside risk of your crypto asset.
Because of its simplicity, the strategy offers an effective, low-cost way for the less-experienced option trader to protect against market volatility.
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