Question

If you owned a stock position how would you construct a “collar” strategy with options?

Answer 1

We own a stock position.

We construct a collar strategy by purchasing a protective put option and selling a call option above the market price.

Example:

Let's say we own 100 shares of a stock at $50 per share.

To protect this stock position from the downside risk, we can purchase a put option at the desired strike price. Let say we need protection only if the stock price drops below $48. We can purchase a put option with a strike price of $48. We pay a premium for this protective put.

To reduce the cost of this protective put, we sell a call option above the market price. For example, we can sell a $52 strike price call option with the same expiry as that of the put option and collect some premium. The premium collected from selling the call option somewhat offsets the premium paid to the put option. By selling a call option we are giving up the upside potential of the stock beyond $52.