An Explanation of the Stock Option Collar

Since I will likely be doing away with my Weebly site on options and pursuing other self hosted blogs, I wanted to write this post here on CFM to explain what a collar is.  There is not much written in books about this type of trade, but it is one that I have been working with in my retirement accounts since 2007.  The reason that I am choosing to write this post now will become obvious later but suffice it to say that understanding it is important if y0u really want to have a good knowledge of options.

Collar Definition

In reality, a collar is really not all that difficult to understand.  It consists of owning a stock (being long), owning a protective put against that stock, and selling a covered call against that same stock.  As always, a real-life example is in order so I will provide just that.

You may have read that I own Intel stock in one of my retirement accounts.  This means that I am long shares of INTC.  I also own put options to protect me against a disastrous drop in price of INTC, as might occur should the company miss earnings.  I currently own the January 2012 $20 puts.  This means that if INTC drops to $15 next week, I can still sell my shares for $20 each.  You can think of put options as portfolio insurance just like homeowner’s insurance if your house burned down or was destroyed by a tornado.

However, insurance costs money.  The puts that I purchased cost me 11 cents per share.  Plus they expire in January.  Even though 11 cents is not a lot of money if I did that every month for 12 months, I would be out $1.32 per share.  That would eat into my returns and wouldn’t make me very happy.  So protective puts can be useful when needed but a waste of money if not needed.

Enter the Collar

So in order to fund the cost of the put options, many investors will establish a collar and sell a covered call against the shares.  It is even possible to make money on the creation of the collar although you don’t often hear about it being used in this fashion.  I was able to sell the January 2012 $25 strike options on Intel for $1.05 per share.  I even only did this on half my holdings so that I could partially participate in any rally.

The net effect was that I was able to pay for the cost of the protective puts and make a small profit on the side.  I received 52.5 cents per share for the covered calls ($1.05/2 since I only sold on half the shares) minus 11 cents per share left me with 41.5 cents per share before the trading commissions.  With commissions I netted 39.5 cents per share.  Plus I received 21 cents per share in dividends on December 1st.

Retirement Account Strategy

I end up doing this a lot on the stocks in my retirement account.  You see, I am not interested in losing a lot of money.  In 2008, I was down 18% because of the collars unlike some of my friends who were down more than 50%!  I would rather protect my capital and decrease volatility while missing out on big gains.

That is why I am shifting more of my funds into stocks that will be paying dividends.  Even though I have almost 3 decades before I will have to start taking distributions, I want to go for steady growth and perfect my methods using the collar for protection of capital.  That way, I can take advantage of being invested in stocks while decreasing volatility and earning income.

Hopefully, this has been fairly easy to understand.  Now, I will confess that I have made mistakes in managing the collars because prices are constantly changing, and I am periodically making adjustments.  The mistakes have come when I fail to follow my own rules (isn’t that always the case).  I figure in three decades I will be more disciplined.  So, one of the commitments that I will have to make for 2012 is to follow my own rules!

Readers:  Is the collar fairly easy to understand conceptually?  What questions about the collar do you have?  Feel free to ask or discuss in the comments.

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