A collar is an option trading strategy that works by holding shares of the underlying stock while simultaneously buying out-of-the-money protective puts and selling call options against that holding.
It is a good strategy for investors who want to protect themselves from an unexpected sharp drop in the underlying without the significant initial outlay of writing a covered call.
The collar dramatically narrows the distribution of possible investment outcomes. It reduces both risk and return potentials.
You plan to purchase 100 shares of stock ABC, which is trading at $48 in June. You can establish a collar by writing a JUL 50 covered call for $2 per share while simultaneously purchasing a JUL 45 put for $1 per share. Your initial investment is -$4,800 + $200 - $100 = -$4,700.
Here is the profit and loss worksheet at expiration:
A collar is essentially holding an out-of-money covered call and protective put simultaneously. It is a "maintenance" or neutral strategy.
Costless collars can be established to fully protect existing long stock positions with little or no cost since the premium paid for the protective puts is offset by the premiums received for writing the covered calls.
What about a same-strike collar? The position will be worth the strike price at expiration, no matter what the stock price is at the time. It is essentially a risk-free investment.
If you buy one call and write another call, or buy one put and write another put, you then create an option spread. Spread is used to bet on direction; in the meantime, it gives up part of the profit potential in exchange for the lower cost of the position.
A spread can be a bull spread, if it becomes more valuable when the underlying price rises, or a bear spread, if it becomes more valuable when the underlying price declines. Spreads can be classified by the direction of the initial cash flows. A debit spread requires a cash payment and a credit spread results a cash inflow.
If a moderate rise in the price of the underlying is expected, a bull spread can be created: purchase call options at a specific strike price and sell the same number of calls of the same asset and expiration date but at a higher strike price.
Stock A is trading at $42. You enter a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call for $100. The net cash outflow required is a debit of $200.
Here is the payoff diagram.
Note that the profit and loss diagram for a bull spread is similar to that for a collar.
If the price of the underlying is expected to go down moderately, a bear spread can be created. For example, a bear put spread is buying a higher strike price put option and selling a lower strike price put option of the same underlying with the same expiration date.
Stock A is trading at $38 in June. You enter a bear put spread by buying a JUL 40 put for $300 and writing a JUL 35 put for $100. The net cash outflow required is a debit of $200.
Here is the payoff diagram.
Investors can long or short a calendar spread, which involves buying one option and selling another option of the same type and strike but with a different expiration. A long calendar spread would entail buying a long-dated option and selling a short-dated option of the same strike and type. In fact, the sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright.
This strategy is ideal for a trader whose short-term sentiment is neutral. The motivation is to take advantage of the option time decay and reduce the cost of purchasing a longer-term option (for a long position). Calendar spreads also profit from a rise in implied volatility, since the long option has a higher vega than the short option.
With the stock trading at $135.13, the July 135 call is sold for $10.45 and the September 135 call is purchased for $15.45, for a net cost of $5, which is the maximum risk of this strategy.
In an option combination, both puts and calls are used. The most important option combination is the straddle, which involves the simultaneous buying of a put and a call of the same underlying stock, striking price, and expiration date. It is used when the underlying is expected to experience significant volatility in the near term.
If someone writes both options, it is a short straddle. We discuss long straddle below.
Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200.
A. Oct 15 call and sells an Oct 17 put.
The current stock price should be higher than the exercise price of the put and lower than the exercise price of the call.
A debit spread requires a net cash payment. The long option value exceeds the short option value.
A. JUL 16 put and sell a JUL 14 put.
A is a bear put spread.
A. In the early stages of a calendar spread, it is a neutral trading strategy.
Risk is limited to the net option premium.
Both options will be worthless at this price.
B. bull spread
XL + (cL - cH) = 15 + (1.64 - 0.58) = 16.06
A. the net option premium
Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid
An options trader is indifferent to whether the underlying goes up or down; he expects it to move sharply either way.
In the early stages of a calendar spread, it is essentially a neutral trading strategy.
If the stock price rallies to above $60 at the expiration date, his maximum profit is capped, as he is obliged to sell his shares at the strike price of $60. At 100 shares, his profit is $1000.
(17 - 15) - (1.64 - 0.58) = 0.94
A. If you want to use calendar spread for a bearish strategy, you have to use put options instead of call options.
Both types of options can be used to construct bullish or bearish strategies.
A. JUL 40 call and JUL 40 put
In general, the strike price that is close to the current underlying price is chosen, otherwise there will be a directional bias.
A. Sept 14/17
For example, if the stock price rises to $14.5, the Sept 14 call will be exercised, resulting in a $0.50 gain.
Breakeven Point = Strike Price of Long Put - Net Premium Paid
A. lower than
If the stock price was any higher, the expiring option would have intrinsic value, and if the stock price was any lower, the longer-term option would have less value. Once the near-term option has expired worthless, the investor is left with simply a long call position, which has no upper limit on its potential profit.
A. sell a collar
A straddle is a bet on underlying volatility. If you believe there is no underlying volatility, you may sell a straddle to try to make a profit.
Should the stock price plunge to $48 or lower, his loss is $200, since the protective put allows him to still sell his shares at $48.
This is a same-strike collar, and the risk is completely neutralized.
It is the net premium paid, if the underlying price drops below $15.
(($35 - $30 )* 100 shares/contract) - ($475 - $175) = $200
A. stock price at expiration - strike price + net option premium paid
The maximum loss would occur should the two options reach parity. This could happen if the underlying stock declined enough that both options became worthless or if the stock rose enough that both options went deep-in-the-money and traded at their intrinsic value. In either case, the loss would be the premium paid to put on the position.
II. Time decay
A. I only
An increase in implied volatility, all other things remaining equal, would have an extremely positive impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility (i.e., a higher vega). Be aware that the near-term and far-term options could and probably will trade at different implied volatilities.
The passage of time, all other things remaining equal, would have a positive impact on this strategy in the beginning. That changes, however, once the near-term option has expired and the strategy becomes simply a long call whose value will be eroded by the passage of time. In general, an option's rate of time decay increases as its expiration draws nearer.
Note that there are 2 breakeven points in a straddle. The other one is $36.
The maximum loss occurs when the price of the underlying asset equals the strike price of the options at expiration.
A. The idea behind the calendar spread is to sell time.
Risk is limited to the net option premium.
A: This is why calendar spreads are also known as time spreads. The options trader hopes that the price of the underlying remains unchanged at the expiration of the near-month options so that they expire worthless. As the time decay of near-month options is at a faster rate than longer-term options, his long-term options still retain much of their value. The options trader can then either own the longer-term calls for less or write more calls and repeat the process.