The volatility being experienced in the market often draws in conflicting attitudes – what if we miss a lifetime opportunity to buy XYZ stock AND yet, what if Nifty collapses? Buying stocks and going short futures may not work as the losses mount if markets rush beyond current levels. Writing calls may not work as they cannot protect losses beyond a point. So what does one do? That’s where protective collars come in!
What are Protective Collars
Equity collars, or simply collars, are option strategies employed to hedge, or protect, individual positions at a relatively low cost.
The typical collar is established by holding shares of an underlying stock, purchasing a protective put for stock downside protection, and simultaneously writing a covered call to help finance the purchase cost of the put.
Combining these two options with their differing functionalities essentially “collars” the underlying stock position, using the premium received from the call sold to finance the cost of the protective put. A collar, at its most basic level limits upside participation in the stock in exchange for the downside protection.
While this strategy still allows potential profit up to the short call strike, the primary goal is to provide a floor to protect against losses on the downside.
Creating the collar
a) Buy 1 OTM Put option (Put collar) – lower limit – for protection
b) Sell 1 OTM Call option (Call collar) – upper limit
OTM means Out of the Money. Example, we stand at 9154 on the Nifty so a 9500 Call Option (which has no value for the buyer is OTM) or an 8500 Put Option (which has no intrinsic value for the buyer) are both “out of the money”
Both Call and Put options are out of the money, have the same expiry date and their quantity must be equal
The purchase of an out-of-the-money put option is what protects the trader from a potentially large downward move in the stock price while the writing (selling) of an out-of-the-money call option generates premiums that, ideally, should offset the premiums paid to buy the put.
Lets say the Nifty starts moving to 8500 – then the Put Option (which gives the right to sell Nifty at 8500 even if Nifty were to go to 5000 acquires value rapidly and protection kicks in from 8500 levels. However, since this protection required you to pay a premium, you sold the OTM calls to finance this purchase.
The Limited Profit Potential
The formula for calculating maximum profit is given below:
Max Profit = Strike Price of Short Call – Purchase Price of Underlying + Net Premium Received – Commissions Paid
Max Profit is achieved When Price of Underlying >= Strike Price of Short Call
Selling the call means you sacrificed the upside performance beyond a point. Lets say the Nifty crosses 9500 in the above example, the stocks would rise but you would lose money on the call option.
The formula for calculating maximum loss is given below:
Max Loss = Purchase Price of Underlying – Strike Price of Long Put – Net Premium Received + Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
In regards to the put strike price, at what level does the investor want the downside protection to begin is a key question? Whether 5%, 10% or 15% down. Remember : If the investors buys a put further OTM, it will be cheaper in relative terms, but the stock position will essentially lose more before the long put protection kicks in. The puts that are closer to the current stock price, or at-the-money (ATM), provide more protection at a strike price closer to the stock’s current level, but are more expensive than the further OTM ones.
Alternatively, If the investor prefers that the collar has a net near-zero cost (excluding charges), buying a more expensive put is going to require the sale of an equally expensive call (which implies a strike price closer to the current price); this provides less room for the stock to run up before the upside is capped.
An investor bought 1,000 shares of Nifty at 9150 tomorrow, and still believes in the market’s long-term prospects. She doesn’t want to sell her position, but is concerned about short-term downward movement, as the overall market volatility has begun to increase. The investor determines that she is willing to risk about a 500 point downward move, but wants to be protected against anything greater. What can she do?
If she protective May 2020 puts at the 8600 strike, this will cost her Rs 180 per contract to lock in her hedge . She is less concerned about a substantial increase in the price of Nifty, so she sells calls at the May 9600 strike to generate Rs 180 per contract and finance the Re 180 cost of the protective puts.
This strategy is ideal for someone who is looking for a limited upside but wants to protect against sudden collapses. There are typically two different reasons why an investor might choose the collar strategy;
To limit risk at a “low cost” and to have some upside profit potential at the same time when first acquiring shares of stock.
To protect a previously-purchased stock for a “low cost” and to leave some upside profit potential when the short-term forecast is bearish but the long-term forecast is bullish.
Since they are willing to risk sacrificing gains on the stock above the covered call’s strike price, this is not a strategy for an investor who is extremely bullish on the stock.
Strategy in Motion
What happens if the stock starts moving? Keep in mind that by making adjustments, you have the ability to raise the floor and raise the ceiling to give your stock room to grow. Rolling your options to higher strikes and further out in time accommodates a stock that’s still trending up. If both options are still OTM as expiration nears, you may be able to roll both options into deferred-month contracts to keep some protection in place.
And if the stock does indeed pull back below your put strike? You may be able to roll the put into another strike, or you could exercise your put, knowing that your loss was limited.
If you are holding long term portfolios or are looking at buying some select stocks, now may be a good time to call your relationship manager and create this collar.
Since a put is expensive and a short futures strategy is risky, you may want to create a collar to ride out the volatility expected around the May 3rd lockdown deadline. If your portfolio is high beta, you may anyways be able to gain if you a) Create collars for lets say 70% of the portfolio so upsides are not limited and b) use the Nifty to do so as a high beta portfolio will still generate excess returns.