Exchange-traded funds (ETFs) have enabled investors to quickly and easily capitalize on opportunities around the world. Stock options can help enhance these strategies by effectively controlling upside potential and downside risk. In this article, we’ll explore one such strategy that can help limit downside risk during times of uncertainty without any added expense [see 101 ETF Lessons Every Financial Advisor Should Learn].
What Is an Equity Collar?
Suppose you’ve just purchased the S&P 500 SPDR (SPY, A) with a specific price target and stop loss in mind. Many traders might simply set a stop-loss or take-profit limit order, but stock options provide an alternative that may be attractive in certain cases. Collars are a unique strategy that are perfect for cases like these, effectively setting both of these points via an option contract [see ETF Call And Put Options Explained].
Collars are created by going long in an underlying equity–such as the SPY–and then purchasing a put option to create a floor and selling a call option to create a cap. The premium from selling the second call option reduces the cost of purchasing the put option, often cancelling each other out (“zero-cost collar”) or even providing a small premium income.
For instance, if SPY is trading at 160.00, a collar may look something like this:
|Write Call Option||165.00||$0.28 Received|
|Buy Put Option||147.00||$0.29 Paid|
The resulting collar position was established for just $0.01 per share, and it limits upside to $165.00 per share and limits downside to $147.00 per share.
Since each option represents 100 shares of a stock, collars and other options strategies require that investors hold at least 100 shares of an underlying equity – such as SPY in the example above. Trading options may also require that traders have a brokerage account that supports options trading and possible trading on margin, depending on the position.
Who Is the Collar Options Strategy Right For?
Collar strategies are most commonly used during times of high volatility to limit the downside risk in a given portfolio. In particular, it may not make sense to liquidate a portfolio position in certain cases and instead simply limit risk during a time of uncertainty. Since the two options positions used in a collar typically cancel each other out, this strategy is usually “free” to initiate [see also 10 Questions About ETFs You've Been Too Afraid To Ask].
For example, suppose that you’re concerned about a pending interest rate decision that could send the markets sharply lower. While this is a potential catastrophic risk, you’re otherwise happy with your existing ETF position. Initiating a collar will enable you to reduce the risk during the time of uncertainty for free, while reducing transaction costs by holding onto the ETF.
Fund managers may also use collars to avoid realized gains or losses or tax consequences resulting from the sale of equity at inopportune times.
What Are the Risks/Rewards?
Collars have very well defined risks and rewards relative to many other options strategies, since the trader owns the underlying, and the options limit both upside and downside. The only two risks associated with establishing collars are opportunity costs (from lost profit potential) and the negligible counterparty risk in the event that the other side of the option doesn’t deliver [see also How To Swing Trade ETFs].
Using the SPY example above, if the index moves higher during the time period, your profit will be limited to the strike price of the call option that was sold. Traders can avoid physically selling their stock position–as this is usually a protective strategy rather than an exit strategy–by repurchasing the option at a loss equal to the lost upside.
Using the same example above, if the index moves lower, your losses are limited to the strike price of the put option that was purchased. Collars are often purchased as protective options, so the stock position is usually liquidated in these scenarios. However, if you wish to hold the stock, you can simply sell the option at a profit equal to the covered downside.
How to Hedge Your Long ETF Positions
Investors can use collars to hedge their ETF equity positions fairly easily during times of uncertainty or bear markets. The key to establishing these positions is to ensure that the premium from selling the call option offsets most or all of the premium paid for the put option, since the benefit of a collar is that it’s a fail-safe that can be established “free” of charge [see 13 ETFs Every Options Trader Must Know].
Here’s a brief guide on setting up these hedges:
- Purchase or own at least 100 shares of an equity ETF at a given price (X).
- Sell a call option with a strike price (X+1) that matches your take-profit price.
- Use the premium from the call option to purchase a put option with a strike price (X-1) that matches your stop-loss price, ideally for even-money.
- Monitor the position over time and exit it when the uncertainty is gone.
The Bottom Line
Collars are a useful options strategy for limiting risk during times of uncertainty with very little expense. For instance, an investor concerned about the market moving down from an interest rate decision from the central bank may set up a collar on an SPY position. While upside is limited by the call option sold, downside is also limited by the put option purchased, temporarily limiting risk until the uncertainty has passed without having to sell the ETF position.
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Disclosure: No positions at time of writing.