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Monday, October 17, 2011

Options trading: Collar strategy overview

The 'collar' is one of several types of stock option trading techniques, and is a relatively conservative way to insure investment  gains in corporate shares, and in some cases, a way to multiply dividend profit. The option involves three simultaneous transactions per the Options Industry Council. This  stock option strategy in effect locks in capital gains, for a time, without having to sell shares.  For example, if a shareholder has experienced an increase of .20 cents per share on 100 shares and believes the price of Coca-Cola shares could fall, writing a 'call option' against those 100 shares  pays for the premium of buying the protective put option which increases in value when the share price falls.

In order to fully grasp this stock option strategy it is necessary to understand the component parts of the collar strategy i.e. the long-put and call option. A put option is a bet that increases in value as share prices fall. These transactions can either be 'written' or 'bought'. The writer of a put option buys shares on margin or owns underlying shares, then charges a fee or premium to the buyer. Each stock option is 100 shares and gives the buyer of the option to sell shares at a pre-determined price. If the price per share falls, the buyer of the put option can sell for a profit at the expense of the option writer.

A call option is the inverse of a put option and allows the option holder to buy shares at pre-determined amount. For example, Mr. A buys 10 call options to buy ABC Corporation at $1.00 per share for a cost of .10 cents per share. This means the premium will be 1000 x .10 cents= $100. In order to make a profit above unrealized gains for a call option alone, the price per share must increase more than .10 cents per share. When purchased, a call option is a form of leveraging to higher level than might be possible than buying on margin. However in a collar, the call is leveraged by the underlying shares owned by the seller and the premium is used to purchase the put. The following video summarizes the stock option collar strategy steps:

The Options Industry Council states collar options are good for protecting 'unrealized gains'. In other words, if the share price falls, the collar option covers the cost of that fall while allowing the shareholder to continue holding the underlying shares. It's a slightly bullish strategy and can also be used to claim dividends without risk according to  Michael Thomsett of Minyanville. In both cases the strike price of the options and the cost of the collar premiums is going to be an important factor in determining whether or not the options is a profitable technique to use.

To be profitable and work, the premium from writing the call option should be close to the premium for buying the put option. Additionally, the strike price for both options should be equidistant from the out-of-the-money price which should be the same for both options. For example, if Mr. A writes a call option for ABC Corporation and purchases a 'long-put' option, the out of the money price is ideally $1.00 per share for both option contracts. Moreover, the option cost is also ideally the same; for example, .10 cents per share.