The term equity collar refers to the investment strategy of simultaneously purchasing a put option and writing a call option. Equity collars are used by investors to limit the downside risk of an equity they own.
While an equity collar can help reduce the downside risk of a stock, they also limit the security's upside potential. Equity collars are of interest to individuals that have an unusually large proportion of their portfolio invested in a single security. For a variety of reasons, the investor may be reluctant, or unable, to reduce their exposure to a single stock. Equity collars allow these individuals to protect their investments with little, or no, cost.
The strategy involves the simultaneous purchase of a put option and the writing of a call option on the same security. Both options will typically have the same expiration date and will be out-of-the-money. One put option is purchased and one call option is written for every 100 shares of the security the investor wishes to protect.
An investor owns 10,000 shares of Company ABC stock, currently trading at $90.00 per share. To limit downside risk, the investor purchases 100 put options, expiring in 10 months at $80.00 for $9.50 per share. Simultaneously, the investor writes 100 call options, expiring in 10 months, at $110.00 for $9.00 per share. The net cost of this protection is the difference between the purchase price of the put options ($9.50 x 10,000, or $95,000) and the premium received for writing the call option ($9.00 x 10,000, or $90,000), which in this case is $5,000.
In this example, there are three possible outcomes at expiration:
If Company ABC stock trades below $80.00 per share, the investor has the right to sell their shares at the strike price of $80.00. Under these conditions, the investor absorbs a loss of $10.00 per share, or $100,000 plus the $5,000 net cost of the options. The downside risk winds up being $10.50 per share.
If Company ABC stock trades above $110.00 per share, the investor will be assigned and forced to sell their 10,000 shares at the strike price of $110.00. Under these conditions, the investor realizes a gain of $20.00 per share, or $200,000, minus the $5,000 net cost of the options. The upside potential winds up being $19.50 per share.
If Company ABC stock trades between $80.00 and $110.00, both options will expire out-of-the-money. Under these conditions, the investor keeps their stock and realizes a loss of $5,000 associated with the net cost of the options.