What is Collar Options Trading Strategy

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Everyone wants to multiply their wealth. However, those who understand the external factors that affect the returns on the money always turn to the Indian financial market for multiplying their wealth.

The Indian financial market is full of numerous investment opportunities that can offer higher returns with low-risk exposure. Furthermore, when you diversify among various asset classes, the risk factor decreases. One of the best ways, along with the equity market, is leveraging various Options Trading strategies to trade Options. They are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expires at a fixed price.

As there are numerous options trading strategies, very few offer steady profits with a very low-risk profile. One such strategy is Collar Options Strategy which combines one extra contract to lower the risk by a huge margin. However, before understanding the Collar Options Strategy in detail, below are some basic terms associated with Options Trading.

Collar Options Strategy Terminology

  • Call Options: A Call Option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties.

  • Put Options: A Put Option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the price on the date agreed upon by the contracting parties.

  • Strike Price: The price at which the options contract was initially bought or the pre-determined price.

  • Spot Price: The current price of the underlying asset is attached to the options contract.

  • Premium: It is the price you pay to the seller of the option for entering into the online trading options.

  • In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.

  • Out-of-the-money (OTM) option: When the underlying asset price is lower than the strike price.

  • At-the-money (ATM) option: When the underlying asset price is identical to the contract’s strike price.

What is the Collar Options Strategy?

The Collar Options Strategy is almost identical to a Covered Call Options Trading Strategy but includes buying another Put Option. Under the Collar Options Strategy, the Put Option reduces the risk factor in case the price of the underlying asset falls below the strike price of the contract.

Overall, the Collar Options Strategy includes buying an ATM (at-the-money) Put Option and simultaneously selling an OTM (out-of-the-money) Call Option. The Collar Options Strategy is a low-risk strategy as the Put option manages the downside risk of the whole transaction. Selling the Call option produces profits for the investor and ideally offsets the cost of buying the extra Put option.

How does a Collar Options Strategy work?

For a detailed understanding of how the Collar Options Strategy works, consider the following example:

Suppose you are holding the shares of ABC company currently trading at Rs 1,500, or you are planning to buy the shares with a view that the price will go up soon. However, you also want to protect your capital in case the prices go down from the current levels. In such a case, you can implement the Collar Options Strategy, which would look like the below:

  • Buy 1 ATM Put Option with a strike price of Rs 1,200- Rs 1

    Premium Paid: 1×100 = Rs 100

  • Sell 1 OTM Call Option with a strike price of Rs 2,000- Rs 2

    Premium Received: 2×100 = Rs 200

Net Premium: Rs 100 (200-100).

The lot size is 100, and both the contracts have the same underlying asset and expiration date.

Scenario 1: The price of the stocks rises to Rs 2,500

In this case, you can sell the stock and make a profit of Rs 1,000 (2,500-1,000). With the net premium, it will increase to Rs 1,100 (1,000+100). The Put option will expire worthlessly, and you will have to pay Rs 500 for the call option.

Net Profit : Rs (1,000+100-500) = Rs 400

Scenario 2: The price of the stocks falls to Rs 1,000.

On paper, you will lose Rs 500 (1,000-1,500) but you can exercise the Put option to earn Rs 200 (1,200-1000). The call option will expire worthlessly.

Net Loss: (-500+200+100) = Rs 200

As you see, the Put option limits the loss by a huge margin which, otherwise, could have been higher.

When should you use Collar Options Strategy?

The best time to use the Collar Options Strategy is when you expect the price of a certain stock to go higher than the current levels. If it goes higher, you earn the maximum profits through exercising the Call Option and the net credit of premium.

Advantages & Risks associated with Collar Options Strategy

The Collar Options Trading Strategy provides steady profits with less risk as the Put option manages the risk on the downside. However, the profit margin is limited in a Collar Options Trading Strategy and is not preferred by investors who want high profits from their capital.

If you want to trade options but do not want to take on high risk, the Collar Options Strategy is one of the most effective strategies you can use. However, it is best used after detailed research and analysis of the stock to determine whether it will rise in its price. If it does, you can earn good profits from the Collar Options Strategy.