The Option Profit

A collar is placed on the underlying position by selling a covered call and purchasing a protective put. With this strategy, upside appreciation is limited but allows the investor to decrease their downside risk. Typically, the investor would use the premium received from the sell of the call to cover some to all of the cost of the put. The investor gives up the potential for upside gains on the underlying past the covered call strike. In return, the investor limits any loss on the underlying below the put strike price. Below is a hypothetical example of a collar trade and the benefit it would offer an investor assuming XYZ is trading at 100.

Sell the XYZ May 105 covered call for $3 and buy the XYZ May 95 put for $3. The investor has given up any potential gain on her XYZ position above 105 but has capped any loss on her XYZ position to $5. If XYZ is trading between 95 and 105 on expiration, no benefit is realized; however the option trade was executed at no cost.

The Math

If XYZ closes at 110 on expiration, the collar trade capped the gain to $5 on the stock. If XYZ closes at 90 on expiration, the collar trade capped the loss to $5. Maximum gain = $5 if XYZ closes at 105 on expiration.

Refer to Glossary for terms and definitions

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RISK is inherent in any investment. No individual or entity should invest with funds they cannot afford to lose. Option trading is time sensitive and involves risk including, but not limited to, loss of gains and principal. A leveraged investor risks the loss of more than principal. Options do not have to be held until expiration and can be exercised at any point. Option trades can be closed prior to expiration with a gain or loss being realized. It is important that you understand all trades and the risk associated before executing a transaction. The Option Profit provides broad ideas, not individual recommendations, and is not responsible for any losses incurred. Diversification is important with any strategy and should be considered when investing Before trading consult with a financial advisor to determine if option trading is appropriate for you and your financial goals.