Collar

Profit potential is not paramount in a collar, which is a hedging strategy. The issues for the protective collar investor concern mainly how to balance the level of protection against the cost of protection for a worrisome period.

Reading the Words: Call, Put, Strike Price, Premium and Assignment

An option is the right to buy or sell a specified amount or value of a particular underlying interest at a fixed exercise price by exercising the option before its specified expiration date. An option that gives the right to buy is a call option, and an option that gives a right to sell is a put option. Calls convey to the purchaser the right, but not the obligation, to buy shares, and they convey to the seller the obligation to sell shares if the contract is assigned. Puts convey to the purchaser the right, but not the obligation, to sell shares, and they convey to the seller the obligation to buy shares if the contract is assigned.

The option holder is the person who buys the right conveyed by the option. A seller of an options contract can also be referred to as the writer of that options contract. The option writer is obligated, if and when assigned an exercise, to perform according to the terms of the option.

In the case of a physical delivery option, the exercise price, which is sometimes called the strike price, is the price at which the option holder has the right either to purchase or to sell the underlying interest. A physical delivery option gives its owner the right to receive physical delivery of the underlying interest, if it is a call, or to make physical delivery, if it is a put, when the option is exercised.

The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. The premium is paid up front to the seller of the option contract and is non-refundable.

The expiration date is the date on which an option expires. If an option has not been exercised prior to its expiration, it ceases to exist, which means that the option holder no longer has any rights and the option no longer has any value. If the holder of a physical delivery option wishes to buy, in the case of a call, or sell, in the case of a put, the underlying interest at the exercise price, the option must be exercised.

Each American-style option other than a delayed start option may be exercised at any time prior to its expiration. A European-style option may be exercised only during a specified period before the option expires.

The Options Clearing Corporation, known as OCC, is the options industry clearing house. The OCC system is designed so that the performance of all options is between OCC and a group of firms called Clearing Members that carry the positions of all option holders and option writers in their accounts at OCC. To qualify as a Clearing Member, a firm must meet OCC's financial requirements. When an option has been exercised, OCC will assign the exercise in accordance with its rules to a Clearing Member whose account with OCC reflects the writing of an option of the same series.

An option assignment represents the seller's obligation to fulfill the terms of the contract by either selling or buying the underlying security at the exercise price. This obligation is triggered when the buyer of an option contract exercises their right to buy or sell the underlying security. OCC has an established process to randomly assign exercise notices to firms with an account that has a short option position. Once a firm receives an assignment, it then assigns the notice to one of its customers who has a short option contract of the same series. This short option contract is selected from a pool of such customers, either at random or by some other procedure specific to the brokerage firm.

A call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option. If the exercise price of a call is above the current market value of the underlying interest, or if the exercise price of a put is below the current market value of the underlying interest, the call or put is said to be out of the money. Generally, the put and the call in a collar are both out of the money when the combination is established.

If the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, the writer is said to be a covered call writer. Uncovered call writing can involve substantially greater exposure to risk than covered call writing. Under Rule 2360(a)(10) of the Financial Industry Regulatory Authority, known as FINRA, the term covered in respect of a short position in a call option contract means that the writer's obligation is secured by a specific deposit or an escrow deposit, meeting the conditions of Rules 610(e) or 610(g), respectively, of the rules of The Options Clearing Corporation, or the writer holds in the same account as the short position, on a unit-for-unit basis, a long position either in the underlying security or in an option contract of the same class of options where the exercise price of the option contract in such long position is equal to or less than the exercise price of the option contract in such short position. 

The same paragraph provides that the term covered in respect of a short position in a put option contract means that the writer holds in the same account as the short position, on a unit-for-unit basis, a long position in an option contract of the same class of options having an exercise price equal to or greater than the exercise price of the option contract in such short position. Under Rule 2360(a)(36), the term uncovered in respect of a short position in an option contract means the short position is not covered.

How a Collar Works

A collar can be established by holding shares of an underlying security, purchasing a protective put, and writing a covered call on that security. The collar strategy essentially adds a long protective put to a covered call strategy. Usually, the investor will select a call strike above and a long put strike below the starting stock price. There is latitude, but the strike choices will affect the cost of the hedge as well as the protection it provides.

The long put strike provides a minimum selling price for the stock, and the short call strike sets a maximum profit price. The long put provides an acceptable exit price at which the investor can liquidate if the stock suffers losses. The premium income from the short call helps pay for the put, but simultaneously sets a limit to the upside profit potential. The combination can sometimes be established for a net credit.

This strategy establishes a fixed amount of price exposure for the term of the strategy. Both the potential profit and loss are very limited, depending on the difference between the strikes.

A tight collar provides less upside participation and more downside protection than a loose collar. A loose collar utilizes very far out-of-the-money puts and calls.

Maximum Loss

The maximum loss is limited for the term of the collar hedge. The worst that can happen is for the stock price to fall below the put strike, which prompts the investor to exercise the put and sell the stock at the floor price, the put strike. In that case the short call would expire worthless.

The actual loss (profit) would be the difference between the floor price and the stock purchase price, plus (minus) the debit (credit) from establishing the collar hedge. If the stock had originally been bought at a much lower price, which is often the case for a long-term holding, this exit price might actually result in a profit.

Maximum Gain

The maximum gain is limited for the term of the strategy. The short-term maximum gains are reached just as the stock price rises to the call strike. The net profit remains the same no matter how much higher the stock might close; only the position outcome might differ.

If the stock is above the call strike at expiration, the investor will likely be assigned on the call and liquidate the stock at the ceiling, the call strike. The profit would be the ceiling price, less the stock purchase price, plus (minus) the credit (debit) from establishing the collar hedge. The investor should be prepared to relinquish the shares if the stock rallies above the call strike.

If the stock were to close exactly at the call strike, the call would expire worthless, and the stock would probably remain in the account. The profit or loss leading up to that point would be identical, but from that day forward the investor would still continue to face a stockowner's risks and rewards.

Breakeven

In principle, the strategy breaks even if, at expiration, the stock is above (below) its initial level by the amount of the debit (credit). If the stock is a long-term holding purchased at a much lower price, the concept of breakeven isn't relevant.

Volatility and Time Decay

Volatility is usually not a major consideration in this strategy, all things being equal. Since the strategy involves being long one option and short another with the same expiration, and generally equidistant from the stock value, the effects of implied volatility shifts may offset each other to a large degree.

Time decay is usually not a major consideration. Since the strategy involves being long one option and short another with the same expiration, and generally equidistant from the stock value, the effects of time decay should roughly offset each other. For a protective put, the passage of time will have a negative impact on the strategy.

The Collar Compared with the Protective Put and the Covered Call

A long put option added to long stock insures the stock's value. The choice of strike prices determines where the downside protection kicks in. The protective put establishes a floor price under which the investor's stock value cannot fall. No matter how low the stock might fall, the investor can exercise the put to liquidate the stock at the strike price. The maximum loss is limited, and in theory the potential gains on this strategy are unlimited. The protective put buyer pays a premium, which lowers the net profit on the upside, compared to the unhedged stockowner. A protective put is analogous to homeowner's insurance.

A covered call consists of writing a call that is covered by an equivalent long stock position. It provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily forfeiting much of the stock's upside potential. If the stock price rallies above the call's strike price, the stock is increasingly likely to be called away. The maximum loss is limited but substantial: the worst that can happen is for the stock to become worthless, and that loss is reduced somewhat by the premium income from selling the call option. The maximum gains on the strategy are limited.

The collar offers more protection than a covered call, but at a lower up-front cost than a protective put.

Assignment and Expiration Risk

Early assignment of the short call option, while possible at any time, generally occurs only just before the stock goes ex-dividend. Because call holders may seek to capture an impending dividend by exercising, a call writer's chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches. Because stock options are not generally adjusted for ordinary cash dividends and distributions, covered writers of calls are entitled to retain dividends and distributions earned on the underlying securities during the time prior to exercise.

A situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

For an investor selling American-style options, one of the risks is that the investor may be called upon at any time during the contract's term to fulfill its obligations. For a short equity call, the seller of the option must deliver stock at the strike price and in return receives cash, and each contract represents 100 shares.

The option writer cannot know for sure whether or not assignment actually occurred on the short call until the following Monday. However, this is generally not an issue since the investor has stock to deliver if assigned on the call.

An investor who has any reluctance about selling the stock would have to monitor the market very closely and stay ready to act (that is, close out) on short notice, possibly having to pay a higher price to buy the call back. Until the position is closed out, there are no guarantees against assignment.

Collar on a Short Stock Position

To protect or collar a short stock position, an investor could combine a long call with a short put. A long call conveys the right to buy shares, and a short put conveys the obligation to buy shares if the contract is assigned. For a short equity put, the seller of the option is required to purchase the stock at the strike price.

The LEAPS Hedge

Long Term Equity Anticipation Securities, known as LEAPS, are American-style options on certain equities and exchange-traded funds that, upon listing, have terms of greater than 12 months. The collar strategy lends itself to use as a LEAPS hedge, where time value tends to make premiums higher and the period of protection is longer. The purchase of LEAPS puts to hedge a stock position may provide investors protection against declines in stock prices, and professionals often compare the purchase of LEAPS puts to hedge a stock position to purchasing insurance on one's home or car.

Tax Treatment: The Straddle Provisions

Section 1092 of the Internal Revenue Code defines the term straddle as offsetting positions with respect to personal property. A taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property, whether or not of the same kind. The word straddle also names an options strategy. A straddle consists of purchasing or writing both a put and a call on the same underlying interest, with the options having the same exercise price and expiration date.

Under Section 1092(a)(1)(A), any loss with respect to one or more positions is taken into account for any taxable year only to the extent that the amount of the loss exceeds the unrecognized gain, if any, with respect to one or more positions that were offsetting positions with respect to one or more positions from which the loss arose.

Section 1092(c)(4) provides that if all the offsetting positions making up any straddle consist of one or more qualified covered call options and the stock to be purchased from the taxpayer under such options, and the straddle is not part of a larger straddle, the straddle is not treated as a straddle for purposes of that section and Section 263(g). 

A qualified covered call option means any option granted by the taxpayer to purchase stock held by the taxpayer, or stock acquired by the taxpayer in connection with the granting of the option, but only if certain conditions are met. One of the conditions is that the option is not a deep-in-the-money option. A deep-in-the-money option is an option having a strike price lower than the lowest qualified bench mark. Except as otherwise provided in that subparagraph, the lowest qualified bench mark means the highest available strike price which is less than the applicable stock price.

Options Accounts, the Disclosure Document and Sales Practice

Trading options requires specific approval from an investor's brokerage firm. Under FINRA Rule 2360(b)(16)(A), no member or person associated with a member shall accept an order from a customer to purchase or write an option contract relating to an options class that is the subject of an options disclosure document, or approve the customer's account for the trading of such option, unless the broker or dealer furnishes or has furnished to the customer the appropriate options disclosure documents and the customer's account has been approved for options trading in accordance with the provisions of subparagraphs (B) through (D) of that paragraph. 

Under paragraph (b)(16)(B), in approving a customer's account for options trading, a member or any person associated with a member shall exercise due diligence to ascertain the essential facts relative to the customer, the customer's financial situation and investment objectives. 

Based upon such information, the branch office manager, a Registered Options Principal or a Limited Principal—General Securities Sales Supervisor shall specifically approve or disapprove in writing the customer's account for options trading, provided that if the branch office manager is not a Registered Options Principal or a Limited Principal—General Securities Sales Supervisor, account approval or disapproval shall within ten business days be submitted to and approved or disapproved by a Registered Options Principal or a Limited Principal—General Securities Sales Supervisor.

Under paragraph (b)(16)(D), within fifteen days after a customer's account has been approved for options trading, a member shall obtain from the customer a written agreement that the customer is aware of and agrees to be bound by FINRA rules applicable to the trading of option contracts and, if the customer desires to engage in transactions in options issued by The Options Clearing Corporation, other than solely for OCC Cleared OTC Options, that the customer has received a copy of the current disclosure documents required to be furnished under paragraph (b)(16) and that the customer is aware of and agrees to be bound by the rules of The Options Clearing Corporation. Under Rule 2360(b)(11)(A)(i), every member shall deliver the current Options Disclosure Document to each customer at or prior to the time the customer's account is approved for trading options issued by The Options Clearing Corporation, other than an OCC Cleared OTC Option. 

Rule 2360(a)(19) defines an OCC Cleared OTC Option as any put, call, straddle or other option or privilege that meets the definition of an option under Rule 2360(a)(21), and is cleared by The Options Clearing Corporation, is entered into other than on or through the facilities of a national securities exchange, and is entered into exclusively by persons who are eligible contract participants as defined in the Exchange Act.

The disclosure document is titled Characteristics and Risks of Standardized Options. Brokerage firms are required to distribute it to options customers. It is not designed to describe the various potential benefits of options or how investors may use options to enhance their investment strategies or to reduce risk.

Rule 2360(b)(19)(A) provides that no member or person associated with a member shall recommend to any customer any transaction for the purchase or sale (writing) of an option contract unless such member or person associated therewith has reasonable grounds to believe, upon the basis of information furnished by such customer after reasonable inquiry by the member or person associated therewith concerning the customer's investment objectives, financial situation and needs, and any other information known by such member or associated person, that the recommended transaction is not unsuitable for such customer.

Regulation Best Interest provides that a broker, dealer, or natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities, including account recommendations, to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer. 

Under the care obligation, the broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with the recommendation, and to have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. 

The same obligation requires a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer's investment profile and the potential risks, rewards, and costs associated with the recommendation, and that it does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer. 

It also requires a reasonable basis to believe that a series of recommended transactions, even if in the retail customer's best interest when viewed in isolation, is not excessive and is in the retail customer's best interest when taken together in light of the retail customer's investment profile.

Risks

For the purchaser of an option, the premium paid is the maximum loss. Option holders risk the entire amount of the premium paid to purchase the option, and if a holder's option expires out of the money the entire premium will be lost. Extreme market volatility near an expiration date could cause price changes that result in the option expiring worthless.

Option writers may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses. Uncovered call writing can involve substantially greater exposure to risk than covered call writing.

In a collar, the maximum loss is limited for the term of the collar hedge. The long put strike provides a minimum selling price for the stock, and the short call strike sets a maximum profit price. The investor accepts a cap on the stock's upside potential and should be prepared to relinquish the shares if the stock rallies above the call strike.

Options on the Examination

The content outline for the Securities Industry Essentials examination lists options under Topic 2.1.3, Options, in Section 2, Understanding Products and Their Risks. Under that topic the outline lists types of options, puts and calls, and equity vs. index, followed by knowledge of hedging or speculation, expiration date, strike price, premium, underlying or cash settlement, in-the-money and out-of-the money, covered vs. uncovered, American vs. European, exercise and assignment, varying strategies, including long and short, special disclosures, including the Options Disclosure Document (ODD), and the Options Clearing Corporation (OCC) for listed options. Candidates should check the current outline before the examination.

Common Misunderstandings

A collar removes all risk from a stock position. A collar establishes a fixed amount of price exposure for the term of the strategy, and the maximum loss is limited for the term of the collar hedge. The investor adds it as a temporary, slightly less-than-complete hedge.

A collar is designed to produce a profit. Profit potential is not paramount in a collar, which is a hedging strategy, and the call strike sets an upper limit on stock gains.

The put in a collar guarantees that the investor avoids a loss. The actual loss (profit) is the difference between the floor price and the stock purchase price, plus (minus) the debit (credit) from establishing the collar hedge. If the stock had originally been bought at a much lower price, the floor price might actually result in a profit.

The short call in a collar is an uncovered call. A collar can be established by holding shares of an underlying security, purchasing a protective put, and writing a covered call on that security.

Assignment on the short call cannot happen before expiration. Early assignment of the short call option is possible at any time, and it generally occurs only just before the stock goes ex-dividend.

The investor keeps all gains above the call strike. If the stock is above the call strike at expiration, the investor will likely be assigned on the call and liquidate the stock at the ceiling, the call strike.

A tight collar and a loose collar give the same protection. A tight collar provides less upside participation and more downside protection than a loose collar.

A collar costs as much up front as a protective put. The collar offers more protection than a covered call, but at a lower up-front cost than a protective put.

Volatility and time decay are the main concern for a collar. Volatility is usually not a major consideration in this strategy, and the effects of time decay should roughly offset each other.

Key Points

A collar is an options strategy in which an investor writes a call option and buys a put option with the same expiration as a means to hedge a long position in the underlying stock.

The put strike establishes a minimum exit price, the floor, and the call strike sets an upper limit on stock gains, the ceiling.

The maximum loss and the maximum gain are both limited for the term of the strategy, and profit potential is not paramount in a strategy that is a hedge.

The collar offers more protection than a covered call, but at a lower up-front cost than a protective put.

The short call can be assigned at any time, and early assignment generally occurs only just before the stock goes ex-dividend.

Trading options requires specific approval from the investor's brokerage firm, and the customer's account must be approved, and the appropriate disclosure documents furnished, before a member accepts an order to purchase or write an option.