Collar

What it is and when to use it

A collar is a protective put that pays for itself. The problem with a bare put is the cost — 5.7% a year in the example on its own page — and the collar solves it by selling an out-of-the-money call whose premium covers the policy. In exchange, you give up the upside above the short strike: you trade upside potential for downside protection, without putting up money.

You use it when you have a large position you do not want to or cannot sell — for tax reasons, because of inherited concentration, because of a lock-up — and you need to limit the risk for a while. It is also the standard structure for getting through a specific period of uncertainty while keeping the exposure.

What defines a collar is the width of the band, not the cost. With a floor at 561.44 and a ceiling at 601.44 you have turned an equity position into something that moves inside a 6.9% range. If that band is too narrow for what you need, the collar is not the tool: selling part of the position is.

How it is built

• Hold 100 shares of the underlying per collar.
• Buy 1 out-of-the-money put — your floor.
• Sell 1 out-of-the-money call — your ceiling, and what pays for the floor.
• Adjust the two strikes until the net cost is what you want: zero, a credit or a small debit.

The "zero-cost" collar is the one everybody names and there is nothing special about it: it is the point where the two premiums match. What matters is not that it comes out at zero, but where the floor and the ceiling land when it does.

A full worked example

100 shares of SPY at 580.00 — $58,000 — with the 560 put bought and the 600 call sold, both at 45 days.

Net credit = 1.44 × 100 = +$144. Effective floor 561.44 and effective ceiling 601.44.

The collar goes on for a credit, so the protection is not merely free: you are paid $144 to accept it. That happens because the 600 call is 20 points from price and the 560 put is too, and the volatility smile does not fully offset the advantage cost of carry gives the calls.

Maximum profit, maximum loss and break-evens

That seven-percentage-point band is everything that can happen in 45 days. Against the shares alone, which over that period can do anything, the collar changes the nature of the asset far more than its zero cost suggests.

• Maximum profit = (call strike − purchase price + credit) × 100 = (600 − 580 + 1.44) × 100 = $2,144.
• Maximum loss = (purchase price − put strike − credit) × 100 = (580 − 560 − 1.44) × 100 = $1,856.
• Break-even = purchase price − credit = 580 − 1.44 = 578.56.
• Range of outcomes = from −$1,856 to +$2,144 on a $58,000 position: between −3.2% and +3.7%.

The ratio is slightly favourable — $2,144 up against $1,856 down — and it is not always. With equidistant strikes, the relationship depends on the slope of the volatility smile: the more expensive puts are relative to calls, the worse the collar comes out.

The position Greeks

Adding the 100 shares (delta +100), the long put and the short call:

The +48.4 delta is the figure that surprises most. A collar cuts market exposure to less than half, so if the reason you hold the position was the exposure, the collar is cancelling much of it — which is precisely what was asked for.

Management: when to close, when to roll

If price rises to the ceiling

You can let yourself be assigned and sell at 600, or roll the call up and out paying the difference. The second option usually costs money, so it is worth deciding before the call goes in the money.

If price falls to the floor

The appreciated put can be monetised by closing it and rolling down, which restores protection closer to the new price and often for a credit.

Rolling the whole collar

At expiry, closing both legs and opening another collar at the new level is standard management. Each cycle is a fresh decision about where to put the band.

Watch the dividend

A short call in the money can be exercised early the day before the ex-dividend date. If the reason for holding the shares was the dividend, the collar can cost you exactly that.

Common mistakes

Chasing zero cost at any price

Adjusting the strikes until it comes out free can leave a ceiling only ten points from price. The objective is not to avoid paying: it is that the resulting band is one you can live with.

Putting it on a position you want to hold long term

A collar cuts exposure to less than half and puts a ceiling on it. Repeated over years, it turns a growth position into a capped income product, and that is rarely what was wanted.

Forgetting the tax treatment

In many jurisdictions a sufficiently tight collar can be treated as a sale for tax purposes, or interrupt the holding-period clock. It is worth checking first, especially if the collar existed precisely so as not to sell.

Not counting the delta

Plenty of people put on a collar and go on regarding the position as "100 shares of SPY". At +48.4 delta it behaves like 48, and that changes any portfolio risk calculation built on top of it.