What it means
An option is a contract that gives the right, but not the obligation, to buy or sell an asset at a set price by a set date. A put option gains value when the price falls, so it works like insurance.
A call option gains value when the price rises, so selling one means the seller agrees to give up gains above its strike price. In a collar, an owner of shares buys a put at a lower strike to protect against falls and sells a call at a higher strike to raise cash.
The owner chooses the strikes so that the premium received from the call equals the premium paid for the put, which is why it costs nothing up front. The result is a range, or collar, within which the investment value can move.
Companies and executives use collars when they hold a large block of shares and want to protect value without selling. An executive with stock worth $5,000,000 might use a collar to protect it ahead of a planned sale.
A company may also use a similar structure to fix a range for currency or commodity costs. The trade-off is that nothing is free.
The zero-cost label refers only to the premium, while the true cost is the upside given up above the call strike. Transaction fees, tax treatment and accounting rules also apply, and a collar that is poorly matched to the asset can leave the holder exposed.
The collar needs monitoring until expiry. If the price moves sharply toward either strike, the owner may decide to roll the structure forward or close it early.
Specialist advice is sensible, because tax and legal rules on hedging vary by country and by holder.
In practice
Real-world examples.
Example
A founder holds shares worth $8,000,000 after a stock market listing and is not allowed to sell for six months. She uses a zero-cost collar to protect against a fall. If the share price drops 30%, her put limits the loss to the agreed floor.
Example
A fund manager runs a portfolio of a single large technology stock. He sets up a collar over three months that covers a company announcement on earnings. When the shares jump 20%, he is capped at the call strike, which is less than the full gain.
Example
A mining company uses a collar on its expected copper sales. The put sets a minimum price that protects its budget, and the sold call gives up gains above a ceiling. The treasurer reports the result as a hedge in the company accounts.
Formula
Calculation
Net premium = Put premium paid - Call premium received
Maximum loss = (Share price - Put strike) x Shares
Maximum gain = (Call strike - Share price) x Shares
An investor owns 10,000 shares at $100, worth $1,000,000. She buys a put with a $90 strike for $3.00 a share and sells a call with a $112 strike for $3.00 a share. Net premium = 3.00 - 3.00 = $0. Her maximum loss is (100 - 90) x 10,000 = $100,000, and her maximum gain is (112 - 100) x 10,000 = $120,000, so her result is locked between losing $100,000 and gaining $120,000.Case study
Seen in the real world.
Whitmore Logistics is an illustrative, fictional company whose chief executive holds 50,000 shares at $60 each, worth $3,000,000. She plans to buy a house in a year and cannot afford a big fall in value. She does not want to sell now because she expects the business to keep growing.
Her adviser sets up a one-year collar: buy a put at $54 and sell a call at $70, with the premiums offsetting. Her downside is limited to (60 - 54) x 50,000 = $300,000, and her upside is capped at (70 - 60) x 50,000 = $500,000.
In the illustrative result, the shares rise to $82 over the year. She keeps the gain only up to $70, so she misses out on 12 x 50,000 = $600,000 of potential profit. The lesson is that the collar did its job of limiting loss, but protection always comes at the expense of upside.
Watch out
Common mistakes.
- Believing a zero-cost collar is free, when the real cost is the upside given up above the call strike.
- Ignoring tax and accounting treatment, when these can change the economics for the holder.
- Choosing strikes without thinking about how far the price could move, when a very tight collar may never be useful.
Questions
People also ask.
What does zero-cost mean?
It means the premium paid for the put equals the premium received for the call, so no net cash is paid at the start.
Does a collar remove all risk?
No, it limits losses to a set level and caps gains, but the holder still bears losses down to the put strike.
Who uses collars?
Executives and investors with large holdings, plus companies hedging currency, commodity or interest rate exposure.
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