A collar is an investment strategy that uses options to limit the possible range of positive or negative returns on an investment in an underlying asset to a specific range. In Finance, an investment strategy is a set of rules behaviors or procedures designed to guide an investor's selection of an Investment portfolio. Options are financial instruments that convey the right but not the obligation to engage in a future transaction on some Underlying security, or in a Futures Investment or investing is a term with several closely-related meanings in Business management, Finance and Economics, related to saving In Business and Accounting, assets are everything owned by a person or company (all tangible and intangible property that can be converted into cash. To do this, an investor simultaneously buys a put option and sells (writes) a call option on that asset. Example of a put option on a stock Buy a Put A Buyer thinks price of a stock will decrease Example of a call option on a stock Buy a call The buyer expects that the price may go up The strike price on the call needs to be above the strike price for the put, and the expiration dates should be the same. In options, the strike price, or exercise price is a key variable in a derivatives contract between two parties
After establishing the portfolio in this manner, the return on the portfolio will be between the strike price on the call (potential profit), and the strike price on the put (potential loss), meaning the possible gains and losses will always be within a preset limit. In finance a portfolio is an appropriate mix of or collection of investments held by an institution or a private individual Returns, in economics and political economy are the distributions or payments awarded to the various suppliers of the Factors of production.
Example
Consider an investor who owns 100 shares of a stock with a current price of $5. In financial markets, a share is a Unit of account for various financial instruments including Stocks Mutual funds Limited partnerships Software for Fixed assets management and Stock control developed in 2004. Calls on the stock are traded with a strike price of $7 and puts are traded with a strike price of $3. An investor would construct a collar by buying one put and selling one call. The collar would insure that the gain on the stock will be no higher than $2 and the loss will be no worse than $2. There are three possible scenarios when the options expire:
- If the stock price is above the $7 strike price on the call he wrote, the person who bought the call from the investor will exercise the purchased call; the investor will need to sell the shares at the $7 strike price. For an option Contract, expiration is the date on which the contract expires The owner of an option contract may exercise it indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties and This would lock in a $2 profit for the investor. He only makes a $2 profit, no matter how high the share price goes.
- If the stock price dropped below the $3 strike price on the put then the investor will exercise the put and the person who sold it is forced to buy the investor's shares at $3. The investor loses $2 on the stock, but can only lose $2, no matter how low the price of the stock goes.
- If the stock price is between the two strike prices at the expiration date, both options expire unexercised, and the investor is left with the shares of the stock.
Why do this?
In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. In Investing, Financial markets are commonly believed to have market trends that can be classified as primary trends secondary trends (short-term and secular trends One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?
If it makes more sense to hold on to the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. In Economics and related disciplines a transaction cost is a Cost incurred in making an economic exchange Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received is used for selling the call to buy the put—one pays for the other.
Finally, using a collar strategy takes the return from the probable to the definite. Returns, in economics and political economy are the distributions or payments awarded to the various suppliers of the Factors of production. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their likelihood. The expected return is the weighted-average most likely outcome in Gambling, Probability theory, Economics or Finance. In Statistics, mean has two related meanings the Arithmetic mean (and is distinguished from the Geometric mean or Harmonic mean The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.
References
- Hull, John (2005). John C Hull is a Professor of Derivatives and Risk Management at the Rotman School of Management at the University of Toronto. Fundamentals of Futures and Options Markets, 5th ed. Upper Saddle River, NJ: Prentice Hall. ISBN 0-13-144565-0.
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