Perhaps the most conservative options trading strategy is the collar trade.Perhaps the most conservative options trading strategy is the collar trade.
The collar trade strategy combines stocks and options to limit risk. So if risk is reduced, what’s the catch?
Well, just as you lower the risk, so too do you limit your upside.
It’s a double-edge sword because you can’t lose a whole lot but equally you may not be able to make a big return.
But when you are trading the most volatile stocks, limiting risk may be your priority, even if your upside is capped.
How the Collar Trade Works
A collar trade limits the effects of stock volatility on your portfolio balance.
No matter how high or low a stock goes, the collar trade will have a fixed reward and risk.
The way it works is for every 100 shares of stock you own, you would purchase 1 put option and sell 1 call option.
The put options act as an insurance policy that limit your risk. Even if the stock plummeted, the amount you could lose would be limited to a specific, fixed amount.
But unlike a regular insurance policy where the full cost to buy it comes out of your pocket, the cost of the insurance is somewhat offset in a collar trade by the sale of the call option.
Investing Tip: Collar Trades can significantly reduce account balance swings compared holding volatile stocks alone.
Collar Trade Example: Let’s say the volatile stock you own is priced at $100 per share.
And we’ll imagine that you pay $5 per share (or $500 per contract) for the put option and receive $2 per share ($200 per contract) for the call option.
So the trade might look something like this:
|Put Option @Strike Price 100||$5|
|Call Option @Strike Price 110||$2|
So the risk in the trade is $3 per share or $300 per contract.
The maximum you can make is limited by the call option strike price.
Your upside is capped because when you sell a call option you are obligated to sell your stock if the price rises above the call strike price of $110.
The maximum profit potential is $7 per share, which is the difference between the call strike price of $110 and your net cost basis, which is $100 per share for the stock plus $3 per share for the put option or $103 in total.
If you don’t like the idea of limiting your upside, you can ditch the call option.
This results in a new trading strategy, called The Married Put.
How to Apply
The protective put option is still applied but the call is not sold.
So when would you want to choose the married put vs collar trade strategy?
When you believe the share price has the potential to move significantly higher, the married put may be the better choice.
Even though you take on more risk with the married put strategy (because no call is sold to somewhat offset the put purchase price), the reward to risk ratio may make it worthwhile.
The collar trade is usually the better choice when the share price is in a downtrend and expected to continue trending lower.
Investing Tip: Married Puts limit downside risk while upside potential is theoretically unlimited.