In finance a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range.

A collar is created by an investor being:

• Long the underlying
• long a put option at strike price X (called the "floor")
• Short a call option at strike price (X+a) (called the "cap")

The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. If the premium of the long call is exactly equal to the cost of the put, the strategy is known as a "zero cost collar". [Strictly speaking the name should be "zero premium collar" as the cost of holding the position can be potentially high if the price of the underlying rise above the strike level of the call.]

At expiration the value (but not the profit) of the collar will be:

• zero if the price of the underlying is below X
• positive if the price of the underlying is between X and (X + a)

The maximum value occurs for any price of the underlying above X+a.

Example

Consider an investor who owns one share of a stock with a current price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option, i.e., the cost of the put option less what is received for selling the call option).

There are three possible scenarios when the options expire:

• If the stock price is above the $7 strike price on the call he wrote, the person who bought the call from the investor will exercise the purchased call; the investor will need to sell the shares at the $7 strike price. This would lock in a $2 profit for the investor. He only makes a $2 profit, no matter how high the share price goes.

• If the stock price drops below the $3 strike price on the put then the investor will exercise the put and the person who sold it is forced to buy the investor's share at $3. The investor loses $2 on the stock, but can only lose $2, no matter how low the price of the stock goes.

• If the stock price is between the two strike prices at the expiration date, both options expire unexercised, and the investor is left with the share whose value is that stock price, plus the cash gained from selling the call option, minus the price paid to buy the put option.

Why do this?

In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?

If it makes more sense to hold on to the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received is used for selling the call to buy the put—one pays for the other.

Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.

Collar Topic - Options

In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset (the underlying asset) on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset and a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract.