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Options Strategies Collar

Collar strategy description: Collar is a strategy designed to hedge an underlying security from a potential sharp decline and fund the put acquired by selling the call option contract. It consists of a long put position and a long underlying security position and short call position. If the underlying security devaluates, gaining from the long put contract will compensate, this hedge considered as 'floor' because of its downside hedge characteristics. On the other hand, if the underlying security rises, the investor will benefit partially from the upside and it is because of the short call options contract, moreover, will lose decreasingly from the long put position. No matter how low the stock might fall, the investor can exercise the put option contract to liquidate the underlying security at the strike price. On the upside, assignment to the call option contract could occur and liquidate the underlying security as well.
To sum up, this strategy is designed to protect the underlying security with low or no cost at all, and is generally used for the short term. From another point of view, this is a perfect way to manage portfolio generally bullish and can protect the security from a sudden decline.

Direction outlook: Neutral to bullish. Neutral, this strategy’s cost of carry is positive to diminishing; bullish, the strategy contains positive deltas. On the other hand, protective from an immediate sharp decline, overall neutral to bullish.

Profit potential: Limited. Theoretically depends on the strategy's number of positive deltas.

Loss potential: Limited loss, thanks to the acquired put contract.

Risk / reward: Relatively low ratio because of its 'cap & floor' risk characteristics, divided by a probable limited profit.

Breakeven point: This strategy has only one breakeven point, calculated as follows: stock price + (call premium - put premium) = BP.

Time factor: All other variables unchanged, an option contract typically loses time value premium with every passing day, and the rate of time value losses tends to accelerate as it reaches to the end of its term, the expiration date. As with most long-option positions, the passage of time has a negative impact here. On the other hand, the short-long option position has a positive impact, thus, the collar strategy's cost of carry is positive to almost close to zero, and depends on the premium received for the short call contract and premium paid to acquire the put contract.

Implied volatility: An increase in implied volatility would negatively affect this strategy, all other variables being equal. Volatility tends to boost the value of any long-option position, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower the long strategy's value, regardless of the overall stock price trend. If the strategy's outlook correct and the underlying security will rise, the volatility impact will reduce and if it declines, volatility impact will increase due to the strategy's vega graph. On the downside, vega's values increase and on the upside they will decrease.

Dividends: As you all ready know, dividend positively affects the long put option and short call contracts, and the opposite on a long underlying security. Thus, overall effect is positively but minimal and it should not be an issue when considering executing this strategy.

Assignment: This strategy allows its holder to act upon three scenarios. First, the underlying security will rally. Second scenario, it will decline; and third, stays unchanged. If it rallies and if the strategy's holder will not buyback or and roll the call option contract position about a week to expiration, must know that the contract will be assigned and the outcome is liquidated underlying security and probably a diminishing put option contract. Second scenario the underlying security will drop, than definitely having that put option contract will prevent losses.
This time the strategy holds the long position and has the right to assign and the result is again liquidated security and diminishing.

Examples
The following three examples will demonstrate each strategy analysis, their pros and cons, and also their risk graphs appearance.

The first strategy is constructed as follows. Holding the underlying security, acquire ATM put option contract, write OTM call option contract.

The second strategy is to acquire out of the money put option contract and writing ATM call option contract.

The third is to acquire OTM put option contract and write the OTM call option contract.

Note
Acquiring an ATM put option contract and writing ATM call option contract is similar to selling short a synthetic underlying security. This strategy is completely different. In short, this strategy relies on miscalculation that will lead to an arbitrage profit, by selling synthetic and buying the real underlying security.

Collars
1. Acquire OTM put and short ATM call, holding underlying security. Generally, this strategy is another way to hedge the underlying security position if the investor's concerns are that the security will gain or stays unchanged. This way the cost of hedging is minimized and the cost of carry is positive. A simple way to get minimum protection of the long underlying security's position is by acquiring OTM put option contract.

This time to fund the acquisition, the investor will write ATM call option contract. This strategy's key points are: worst risk / reward ratio about 2/1, most ‘paying’ a 3.25% credit of the underlying security's value, bullish however less protective strategy.

2. Acquire OTM put and short OTM call, holding underlying security.
Generally, this strategy is another way to hedge the underlying security position if the investor's concerns are that the security will gain or stays unchanged. This way the cost of hedging is minimized and the cost of carry is close to zero to positive. A simple way to get minimum protection of the long underlying security's position is by acquiring OTM put option contract. This time to fund the acquisition, the investor will write OTM call option contract. The strategy's key points are: moderate risk / reward ratio about 1/1, no credit no debit, very bullish and the exposes the most on the downside.

3. Acquire ATM put and short OTM call, holding underlying security. Generally, this strategy is another way to hedge the underlying security position if the investor's concerns are that the security will decline or stays unchanged. This way the cost of hedging is minimized and the cost of carry is close to zero or even positive income. A simple way to protect long underlying security position is by acquiring ATM put option contract. This time to fund the acquisition, the investor writes OTM call option contract. This strategy's key points are: best risk / reward ratio, most "expensive" a 3% of the underlying security value, bullish yet protective strategy.