The Collar: Trade Protection for your Covered Call

The option collar is a covered call with downside trade protection. It is one of the safety nets you will consider using if you decide to write covered calls to make them safer. It is established by buying an out-of-the-money put for each 100 shares of stock you own, against which you have sold calls.

You do not have to enter into an option collar by buying the put right away. You can buy stock and sell calls against that stock to collect premium. Then if the stock later rises in price, you can buy puts as trade protection, generating a much less risky situation. In some cases, you might even be able to construct a riskless trade.

Let’s Look at an example: It is April, and you have been following stock XYZ for some time. It has been on an upward trajectory in price, but has recently pulled back a few dollars. Your view is that this pullback is related to temporary market weakness, and you think XYX still has room to move up. You purchase 500 shares at 24.50/share. Because you are attracted to the income potential of selling calls, you sell 5 May XYZ 25’s for 1.20/contract, bringing in $600 of premium before commissions. A week passes and XYX reaches $25.50/share. You decide to purchase a protective put and establish an option collar. You buy 5 contracts of the May 25 for $0.50/contract, costing you $250 plus commissions.

Your option collar has placed you in an excellent position. If you are called out you will sell the stock at 25, make $250 in capital gains (500 shares x $0.50 per share increase), get to keep the $600 in options premium, and be out $250 for the put you bought, which will have expired worthless. This gives you a net gain of $600 minus commissions if called out. If the stock closes below $25, you will get to keep the $600 call premium no matter what. In fact, since you sold the calls for $1.20/ contract, you can afford to have the stock drop to $23.80/share, and still breakeven. If XYZ drops catastrophically to the mid teens, you are wonderfully protected by your put: You can buy back the calls for a very small cost and then instruct your broker to sell the XYZ shares at $22.50, because as a put buyer, you have that right as long as the put option has life. You will emerge from this potential catastrophe with a loss of $2.50/share offset the net you received from selling and subsequently buying back your sold calls - a loss although a much better outcome than the catastrophe.