collar strategy provides downside protection through the use of index
put options but finances the purchase of the puts through the sale of
short index call options, in effect trading away some upside potential.
By simultaneously purchasing put options and selling call options with
differing strike prices and the same expiration (the strike of the put
is lower than that of the call), a collar often can be established for
little or no out-of-pocket cost. The index puts place a "safety net"
under a diversified portfolio by protecting value in a declining market,
"insurance" against the risk of a decline. The index call sale
generates income to offset the purchase of the protective puts. It is
important to note that, depending on the call strike price and the level
of the index at expiration, assignment of the short call position may
have the effect of limiting portfolio gains.
As a simple
hypothetical, assume Fund X maintains a portfolio roughly matching the
composition of the Standard & Poors 500 Stock Index (SPX) and
that the SPX is at 945.
Fund Xs manager wants to
establish a collar to protect $100 million of the funds value from
a market decline of greater than 7 percent for the next 30 days. The
fund manager might determine the number of times to effect the collar by
dividing the amount to be hedged ($100,000,000) by the current aggregate
SPX value (945 x $100 or 94,500), i.e. 100,000,000/94,500 = 1058.2.
Since fractional contracts cannot be purchased, assume the fund
implements the SPX collar by selling 1,058 call options and purchasing
1,058 put options.
To establish the collar, the fund manager
might select an SPX put contract with a strike price approximately 7
percent below the current aggregate SPX value. With the SPX at 945, an
SPX put contract with a strike price of 880 and 30 days until expiration
might be quoted at 4-5/8.
Next, the fund manager may choose to
select a call contract currently quoted at a price sufficient to pay for
the put purchase. With the SPX at 945, an SPX call contract with a
strike price of 995 and 30 days until expiration might be quoted at
This collar can be established for a net credit of
$92,575: $581,900 received from sale of calls (1,058 call contracts sold
x $5.50 premium x $100) less $489,325 paid for purchase of puts (1,058
put contracts purchased x $4.625 premium x $100).
The Index Rises The
portfolio participates in any upside move up to the strike price of
the calls. Above the 995 index level, losses from the short call
position offset gains in the underlying portfolio. The puts expire
The Index Falls The portfolio has
protection on the downside. Below the 880 index level, gains from
the long put position offset losses in the underlying portfolio. The
calls expire worthless.
The Index Remains Stable
If the index remains between the put strike of 880 and the call
strike of 995, the options expire. In this case, the total value of
the portfolio is increased by the $92,575 net premium received.