In order to
protect existing stock positions traders will sometimes put on a position known
as the collar, also known as a fence or cylinder.
When the stock
position is long, the collar is created by combining covered calls and
protective puts. From a profitability standpoint, the collar behaves just like a
bull spread. The upside potential is limited beyond the strike price of the
short call while the downside is protected by the long put.
Example:
Say you have purchased 100 shares of Time Warner (AOL) at $12.85 and would like
to cover the downside with little cost. You would create a collar by buying one
$10 Put for $.60 and selling one $15 Call for $.80.
The
total cost of the trade is $1265 (($12.85 + $.60 - $.80) x 100 shares)
The
breakeven price is at $12.60 where drop in price is covered by premium received.
The maximum profit is assumed when the stock is at $15, above that the profit on
the stock is exactly offset by the loss on the written call. The maximum loss
occurs when the stock is at $10. Below $10 the profit from the put offsets the
loss on the stock.
The collar is a great strategy for investors looking for a conservative strategy that offers a reasonable return with managed risk. The key to the strategy is selecting the appropriate Put and Call combination, which allows for profit, while still protecting the downside risk. Investors will often roll the options each month, and in doing so locking in a 3-5% profit each month. Rolling involves buying back the short calls and selling some new calls for the following month and perhaps a new strike price, and doing the same with the puts. Hence, adjusting the collar to the movement of the stock price.