Protective Index Collars

Definition

The term protective index collar refers to the investment strategy of simultaneously purchasing a put option and writing a call option.  Protective index collars are used by investors to limit the downside risk of a portfolio they own.

Explanation

While a protective index collar can help reduce the downside risk of an investor's portfolio, they also limit its upside potential.  Index collars are of interest to individuals that own a portfolio of securities that closely track the performance of an index.  This strategy involves the purchase of a put to limit downside risk and the selling of a call that limits upside potential.  Index collars may be constructed such that the price received for writing the call option exceeds the price paid for the put.  Using this strategy, the investor effectively receives free "insurance" provided by the protective put option.

When constructing the collar, the strike price on the put becomes the floor price for the index while the call's strike price places a cap on profits.  Both options will typically have the same expiration date and will be initially out-of-the-money.  One put option is purchased and one call option is written for every 100 shares of the index the investor wishes to protect, which should correspond with the dollar value of the investor's portfolio they wish to insure.

Investors interested in protective index collars should keep in mind that American options allow for assignment at any time before the contract's expiration date, while European options allow for assignment typically the day before the contract expires.  Finally, index options are always cash-settled.

Example

An investor possesses a portfolio of technology stocks valued at $5,000,000 and the performance of that portfolio closely matches the performance of Index ABC, which currently trades at $5,000.  To protect the unrealized gain on the technology stocks, the investor purchases a number of collar options, calculated as:

= Value of Portfolio to be Protected / (Index Value x Multiplier)
= $5,000,000 / ($5,000 x 100)
= 10 collars

In this example, the investor's collar would consist of 10 puts and 10 calls on Index ABC, with an expiration of 90 days.  The investor decides to purchase a put with a strike price that is 6% below Index ABC's current trading price, or $4,700, so the put purchased is 90-day ABC $4,700.  At the same time, the investor sells 10 call options, 90-day ABC $5,300. The price of the put option is $30.00, or $3,000 per option, while the selling price of the call option was $28.00, or $2,800 per option.  In this example, the net cost of each collar is $3,000 - $2,800, or $200.  There are three possible outcomes at expiration.

Index Price Declines

If Index ABC trades at $4,500, the investor's put will be in-the-money and they have a right to settle their position in cash for $4,700 (strike price) - $4,500 (index price) x 100 multiplier, or $20,000 per put.   Under these conditions, the investor would receive a total of $20,000 per put x 10 options, or $200,000.  The call options expire out-of-the-money.  While it may seem like a windfall for the investor, keep in mind the value received from the put is used to offset the loss on the investor's portfolio.  Assuming the value of the portfolio tracked well with Index ABC, the portfolio would be worth $4,500,000 + $200,000 cash settlement, or $4,700,000.

Index Price Increases

If Index ABC trades at $5,500, the investor's call will be in-the-money.  They will be assigned and obligated to settle their position in cash for $5,500 (index price) - $5,300 (strike price) x 100 multiplier, or $20,000 per call.  Under these conditions, the investor would be required to settle their 10 options for $200,000.  The put options expire out-of-the-money.  While it may seem like the investor realized a large loss, keep in mind the increase in the investor's technology portfolio can be used to offset the loss on the call option.  Assuming the value of the portfolio tracked well with Index ABC, the portfolio would be worth $5,500,000 - $200,000 cash settlement, or $5,300,000.

Index Price Falls Between Contracts

If Index ABC stock trades between $5,300 and $4,700, both options expire out-of-the-money.  Under these conditions, the investor realizes a loss of $200 x 10 collars, or $2,000, associated with the net cost of the options.

Related Terms

equity collars, equity LEAPS puts, equity LEAPS calls, index calls