The term collar refers to an options strategy involving both the purchase of protective puts and the selling of call options. Collars also require the investor to hold shares of the underlying securities.
A collar is an options strategy that can protect an investor against a large loss, while at the same time limiting their potential for a large gain. The approach involves the purchase of an out-of-the-money put option, which protects the underlying securities from a loss due to a price decline. This part of the collar is known as a protective put. The investor also sells an out-of-the-money call and uses the premium received to help offset the price paid when buying the put. Ideally, the underlying securities continue to increase in value until the strike price is reached. Since the investor also owns the underlying securities, this part of the collar is also referred to as a covered call.
The maximum gain possible with a collar occurs when the price of the securities reach the call option's strike price; when this happens, the profit would be:
= Strike Price of Call - Purchase Price of Securities + Net Premium Received
The maximum loss possible with a collar occurs when the price of the securities reach the put's strike price; when this happens, the loss would be:
= Purchase Price of Securities - Strike Price of Put - Net Premium Paid
Finally, breakeven occurs when the price of the securities is equal to the original purchase price of the securities plus the net premium paid to establish the collar.