Index XYZ is below 95 put strike price at expiration
XYZ Index at 100
Buy 100 XYZ 95 Puts at $0.60
Sell 100 XYZ 105 Calls at $0.80
Say index XYZ drops 8% and closes below the put strike put strike price of $95 at expiration, at a level of 92. The puts will be in-the-money, and if sold for their total intrinsic value of $300, or exercised for their cash settlement amount of $300 ($95 strike price – 92 index level x 100 multiplier), the investor will receive for the 100 puts a total of: $300 put value x 100 contracts = $30,000. The out-of-the-money calls would expire with no value.
The expected drop in value of the portfolio, if it in fact tracks the performance of index XYZ, would be the 8% decline seen in index XYZ, or $80,000. However, the investor was originally willing to tolerate a decline of 5%, or $50,000, and to insure the portfolio only below that level. With an expected $80,000 loss in portfolio value after this market drop, less the $30,000 received from either selling the puts at expiration or exercising them, the investor has limited the downside loss to 5%, or $50,000, the original goal. This loss could be expected if index XYZ closed at any point below the 95 put strike price at expiration.
But remember, this investor received a net credit of $2000 when establishing the collar position. This credit is kept, and to a limited extent offsets the loss on the portfolio to:
$50,000 – $2000 = $48,000 total. If the collar had been originally established at a net debit, this would instead add to the limited downside loss of $50,000 by the total debit amount.