As an investor in a volatile market, it can be stressful worrying about gains turning into losses from day to day. One strategy to protect your gains is through protective collar options.
Protective collars provide inexpensive near-term downside risk protection on a long stock position, but the strategy also limits your upside.
What Is a Protective Collar?
A protective collar is a three-part strategy:
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A long position in a previously purchased underlying asset that has seen a large price increase you wish to protect.
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A long put option, also known as a protective put, that provides downside protection to your asset gains.
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A call option with the same expiration date as the long put written on the underlying asset, also known as a covered call. Writing this call offsets the cost of purchasing the long put option, but it will also limit the future potential gains on the underlying asset.
As with other options strategies, when you reduce risk, you must give up something in return. In the case of a protective collar option strategy, you limit your upside since you are short calls. Additionally, the sale of calls helps reduce the overall cost of the transaction. It might even be possible to construct a protective collar that generates income when initiated.
Collars in options trading help address price risks. The term “collar” refers to the strike prices of the two options being above and below the price of the underlying asset. The put strike is typically below the current share price while the short call strike is above the price of the underlying asset. Profits are capped at the short call strike price and losses are capped at the long put strike price.
How Do Protective Collars Work?
Protective collars work to hedge against the risk of a near-term drop on your long stock holding without having to sell shares. It’s one of many strategies for options trading to manage risk. If you have a sizable gain on your shares, you might not want to trigger a taxable event by liquidating the position.
Protective collars have many beneficial features:
• Protective collars allow you to initiate the trade cheaply. A protective collar option can be done at a net debit, net credit, or even without cost, known as a “zero-cost collar”.
• Protective collars provide downside risk protection at a level you determine. You will be purchasing a long put. By choosing a put that’s at the money, you will protect the most loss, but at the highest cost.
Conversely by choosing a long put that is out of the money, you pay less up front, but the accepted potential loss will be higher.
• Protective collars allow you to participate in further asset increases, again at a level you determine. By writing a call that’s at the money, you earn the highest premium but limit upside participation and increase the likelihood your shares will be assigned and sold.
• By choosing to write calls that are far out of the money, you will earn lower premiums that can offset the cost of the purchased put option but allow continued participation in any future asset increases. Additionally, the likelihood that the call will be exercised and assigned is lower.
Recommended: Guide to Leverage in Options Trading
Maximum Profit
The maximum profit on a protective collar options position happens at the short call strike. The highest profit is limited to the high strike minus the net debit paid or plus the net credit received when executing the options trade.
Maximum Profit = Short Call Strike Price – Purchase Price of Stock – Net Debit Paid
OR
Maximum Profit = Short Call Strike Price – Purchase Price of Stock + Net Credit Received
Maximum Loss
The maximum loss on protective collar options is limited to the stock price minus the put strike minus the net debit or plus the net credit received.
Maximum Loss = Long Put Strike Price – Purchase Price of Stock – Net Debit Paid
OR
Maximum Loss = Long Put Strike Price – Purchase Price of Stock + Net Credit Received
Break Even
Theoretically, there are a pair of break-even prices depending on how the initial trade was constructed. If it was a net debit protective collar, then the break even is the stock price at trade initiation plus the net debit paid. If the options trade was executed at a net credit, then the break even is the stock price at trade initiation minus the net credit.
Break Even = Stock Price at Trade Initiation + Net Debit Paid
OR
Break Even = Stock Price at Trade Initiation – Net Credit Received
However, for an asset that has seen significant appreciation, the concept of break even is almost irrelevant.
Constructing Protective Collars
Putting on a protective collar strategy might seem daunting, but it is actually quite straightforward. You simply buy a low strike put option and simultaneously sell an upside call option. Of course, you must already own shares of the underlying stock.
The protective put hedges downside risk while the covered call caps gains but helps finance the overall trade. Both options are usually out of the money.
Pros and Cons of Protective Collars
| Pros | Cons |
|---|---|
| Limits losses from a declining stock price while still retaining ownership of the shares | Upside gains are capped at the call strike |
| There remains some upside exposure | Losses can still be experienced down to the long put strike |
| Protective collars are cheaper than purchasing puts only | Slightly more complicated than a basic long put trade |
Recommended: Margin vs. Options Trading: Similarities and Differences
When Can It Make Sense to Use Protective Collars?
You might consider implementing a protective collar options position when concerned about near-term or medium-term declines in an equity holding. At the same time, you do not want to sell your shares due to a large taxable gain. For that reason, protective collar options might be more likely to be used in taxable accounts rather than tax-sheltered accounts like an IRA.
With the downside risk hedge also comes the risk that your shares get “called away” if the stock price rises above the short-call strike.
A protective collar can work well during situations in which the market or your individual equity positions lack upside momentum. A sideways to even down market is sometimes the best scenario for protective collar options. During strong bull markets, the play is not ideal since you might see your shares vanish when the underlying stock price gets above the short call strike.
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Protective Collar Example
You own 100 shares of XYZ company that you paid $50 for, and the stock is currently trading at $100. You’re concerned there might be a move lower on your equity stake, but you do not want to trigger a taxable event by selling.
A protective put is an ideal way to address the risk and satisfy your objectives. You decide to sell the $110 strike call for $5 and buy a $90 strike put for $6. The total cost or net debit is $1 per share or $100 per option, each option represents 100 shares.
If the price rises above the short call strike price of $110 to $115:
Unrealized Profit on Stock Position = Current Price – Purchase Price
Unrealized Profit on Stock Position = $11,500 – $5,000 = $6,500
Maximum Profit = Short Call Strike Price – Purchase Price – Net Debit Paid
Maximum Profit = $11,000 – $5,000 – $100 = $5,900
You have given up $600 of potential profit to protect your downside risk.
If the stock trades anywhere between $90 and $110, For example $105:
Unrealized Profit on Stock Position = Current Price – Purchase Price
Unrealized Profit on Stock Position = $10,500 – $5,000 = $5,500
Profit = Current Price – Purchase Price – Net Debit Paid
Profit = $10,500 – $5,000 – $100 = $5,400
You have paid $100 to protect your downside risk. It may also have been possible to choose options that would have allowed you to profit on the protective collar.
If the price drops below the long put strike price of $90 to $85:
Unrealized Profit on Stock Position = Current Price – Purchase Price
Unrealized Profit on Stock Position = $8,500 – $5,000 = $3,500
Maximum Loss = Long Put Strike Price – Purchase Price of Stock – Net Debit Paid
Maximum Profit = $9,000 – $5,000 – $100 = $4,000
You have avoided additional losses of $500 by purchasing the protective collar.
Collars and Taxes
Nobody likes paying unnecessary capital gains taxes. Protective collar options can be used to avoid that scenario. The strategy offers downside risk control while allowing you to keep your shares.
You still might be required to sell your stock to the holder of the calls you wrote, though. If you decide to sell your shares to the put owner, that too will trigger a taxable sale. The potential taxes can’t be avoided using this strategy, but they can be deferred, let’s say into next year, and this can be valuable in itself.
The Takeaway
Protective collar options are used to guard against near-term losses on a long stock position. The combination of a protective put with a covered call offers a low-cost way to help control risk. It can also be a tax-savvy move to protect an unrealized gain without triggering a taxable event as you would when selling shares.
If you’re ready to try your hand at options trading, SoFi can help. You can trade options from the SoFi mobile app or through the web platform. And if you have any questions, SoFi offers educational resources about options to learn more.
FAQ
Are protective puts worthwhile? When does it make sense to buy protective puts?
Protective puts can make sense if you are concerned about bearish price action on your underlying stock position. They are worthwhile if you have a strategy with respect to timing, direction, and price of the trade.
What does protective, covered, and naked mean in options?
“Protective” in options trading refers to having downside risk protection should a stock position drop in price. A protective put, for example, rises in value when shares fall.
“Covered” in options parlance means that you are writing call options against an asset you currently own.
“Naked” is when you are writing call options that you do not currently own.
What are the benefits of collar trades?
Protective collar options trades are used when you are bullish on a stock but are concerned about near-term downside risk. A major benefit is that the strategy helps to cushion losses if the underlying stock drops. Since the strategy assumes you own shares of the underlying asset, a combination of a protective put and a covered call help to keep costs low on the trade. That is a major benefit to traders looking to protect a long stock position.
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