How to Use an Equity Collar
Collars are used mostly by investors who have accumulated a large position in a given stock (through an employee stock purchase plan, for example) and who are primarily concerned about the downside risk of their holdings. These investors may be reluctant to sell their stock for a variety of reasons: the tax liability could be substantial, or selling an employer's stock may be sending the wrong kind of signal to management or other shareholders. These investors are also willing to give up some of the stock's upside potential in order to obtain the desired downside protection at little or no cost.
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
As an example, consider an investor who has accumulated 1,000 shares of XYX stock, now trading at $44.75. This investor may be familiar with the purchase of protective puts but may also be reluctant to spend the amount necessary to buy put options. This could be especially true if the desired protection is for a relatively long period of time. If a 10-month 40 put option on XYX could be purchased for $4.75, for example, the investor might be unwilling to pay such a high premium.
In order to lower the net cost of the protection, the investor could purchase 10 of the 10-month 40 puts, and, at the same time, sell 10 of the 10-month 55 calls for $4.50. The cost of the put options can be partially if not fully offset by the premium received from writing the call options. If the collar could be established for no net premium, then it would be what is commonly known as a zero-cost collar.
The investor's 10-month $40-$55 equity collar transaction would look like this:
Consider three possible scenarios at expiration:
- XYX closes above the call strike of $55
- XYX closes below the put strike of $40
- XYX closes between $40 and $55