Establishing an index collar to protect a portfolio involves purchasing puts for downside insurance, while at the same time selling calls, with the premium taken in at least in part financing the cost of the puts. The purchased puts will have a strike price less than that of the calls sold, and very commonly both options are out-of-the-money when the position is established. The short calls will limit upside profit potential of the portfolio, the degree to which depending on the strike price chosen, because they expose the investor to potential assignment on in-the-money contracts. Assignment may be received on American-style index options at any time before the contracts expire. For European-style index options, assignment is possible only within a specific period of time, generally on the last business day before expiration. All index options are cash-settled. For contract specifications for various index option classes, please visit the Index Options Product Specification area here.
The degree to which the collar’s protective puts are paid for by the premium received from the written calls depends entirely on the current level of the underlying index, and the strike prices and premium amounts of the contracts chosen. It is possible to construct a collar so that not only are the puts fully paid for by the call premium, but that the call premium actually exceeds the puts’ cost. In other words the whole position may established at a net credit, which the collar investor keeps whether the level of the underlying index increases, decreases or remains unchanged.
Index collars are generally employed to protect unrealized profits from the portfolio being protected, and the index option class chosen will generally have an underlying index that most closely tracks the performance of the portfolio, or at least at a consistent correlation, or beta. There are many option classes available from which a collar might be constructed to provide the downside protection a portfolio might need. Again, losses on the downside are limited by the protective index puts, as well profits on the upside capped by the written index calls.