A collar strategy is a defensive equity play in which an investor seeks to limit the downside in a stock in exchange for forgoing some of the upside potential. This strategy is also known as a hedge wrapper.
The investor buys a long position in a stock, in which he will benefit if the price goes up, although the strategy can also be accomplished without actually buying the underlying stock. At the same time, he also buys an out-of-the-money put option on the stock and sells an out-of-the-money call option, both with the same expiration date. Out of the money means that the option doesn't have any inherent value: the price of the stock is higher than the strike price of the put option and lower than the strike price of the call option.
Here's an example: The investor buys 100 shares of ABC Corp. at US$50 a share. At the same time, they buy a put option with a strike price of US$45 and sell a call option with a strike price of US$55. If the stock price falls, the investor stands to lose no more than US$5 a share because the put option is triggered. But if the share price rises, the investor's gain is capped at US$5 a share because of the call option. In other words, the investor maximizes their potential gain at US$5 but limits the potential loss to no more than US$5 a share.
Why Would I Use A Collar Strategy?
Generally, investors use collar strategies because they believe in the long-term upside potential of the stock but are worried about a near-term decline in the overall market, which may drag down the price of the stock. Likewise, they may be bullish on the stock's long-term potential but bearish short-term. Investors also use collars to lock in a profit while being willing to sacrifice some upside.
A collar strategy is also sometimes used by activist investors and hostile takeover artists to build up an equity position in a target company while providing protection in the event their plan fails and the stock price of the target company falls.
Example Of A Collar Strategy
For example, the activist investor Edward Bramson has built a 5.5% stake in Barclays PLC in the hopes of winning a seat on the bank's board of directors in order to influence the bank's business strategy. According to media reports, Bramson's firm, Sherborne Investors, built its stake with the help of a US$1.4 billion loan from Bank of America that includes "a series of put and call options that protect him from losses if the shares fall below a certain level while also limiting his upside."
"The funded equity collar has become popular in recent years with highly acquisitive groups such as SoftBank because it allows them to amass large positions in publicly traded stocks with much more leverage than a traditional loan," according to the Financial Times.
A collar strategy is a defensive equity play in which an investor seeks to limit the downside in a stock but caps the gain if the price goes up. The strategy, also known as a hedge wrapper, involves buying an out-of-the-money put option to protect the downside risk and simultaneously selling an out-of-the-money call option that limits the gain. The strategy has also been used by activist investors to protect themselves in hostile takeovers.
Hypothetical/Simulated Performance: These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Simulated or hypothetical trading programs are generally designed with the benefit of hindsight, do not involve financial risk, and possess other factors which can adversely affect actual trading results.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…