Case study: using collars to balance risk and reward

Introduction:

Investors seeking to protect their investments while still allowing for some upside potential often turn to the collar strategy. A collar involves holding a stock, buying a protective put, and selling a call option on the same stock. This approach limits both the downside risk and the upside potential. The premium received from selling the call option helps offset the cost of the protective put, making this a cost-effective way to hedge a position. Collars are particularly useful for investors who want to secure their investments against significant losses while still participating in moderate gains.

Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Background:

Anna, a prudent investor, owns 400 shares of Fictitious Inc., currently trading at $100 per share. Anna has a long-term investment horizon and is confident in the growth potential of Fictitious Inc. However, she is also cautious and wants to protect her investment from potential market downturns. At the same time, Anna wants to generate additional income to enhance her portfolio returns.

Challenge:

Anna wants to protect her investment from significant losses without completely sacrificing potential gains. She is looking for a strategy that allows her to stay invested in Fictitious Inc. while providing a safety net against major declines and generating some income.

Solution: Using Collars:

To achieve her goals, Anna decides to use a collar strategy. She buys 4 protective put options on Fictitious Inc. with a strike price of $90, expiring in 60 days. At the same time, she sells 4 call options on Fictitious Inc. with a strike price of $110, expiring in 60 days. The premium received from selling the call options is $2 per share, which offsets the $2 per share cost of the put options, making the collar strategy cost-neutral.

Financial Comparison:

• Current Holdings: 400 shares of Fictitious Inc. at $100 each, totaling $40,000.
• Put Option Purchase: Premium paid: $2 per share; Total cost: $800.
• Call Option Sale: Premium received: $2 per share; Total income: $800.
• Net Cost of Collar: $0 (the premiums offset each other).

Outcome and Analysis:

• If Fictitious Inc. trades at $100 at expiration:
  • Anna retains her shares, and both the put and call options expire worthless. She has no additional income or cost from the options.
• If Fictitious Inc. trades at $80 at expiration:
  • Anna exercises her put options, selling her shares at the $90 strike price. Her effective sale price is $90 per share, protecting her from further losses.
• If Fictitious Inc. trades above $110 at expiration:
  • Anna's shares are called away at the $110 strike price. She gains $10 per share from the stock appreciation, totaling $4,000.

ROI and Yield:

• Cost of Protection: The collar strategy is cost-neutral, as the premium received from selling the call options offsets the cost of the protective puts.
• Balanced Risk and Reward: The collar provides downside protection by ensuring Anna can sell her shares at $90, while also allowing her to participate in gains up to $110.

Conclusion:

By using collars, Anna effectively balances risk and reward. This strategy protects her investment against significant declines while still allowing for moderate gains. The collar is a cost-effective way to hedge her position, as the premiums offset each other. This makes collars an ideal strategy for investors who want to safeguard their portfolios without giving up all potential for upside.