A collar is a relatively low-cost way to hedge your shares
Earnings season is here once again, and investors are understandably more on edge. Earnings create volatility -- and for many shareholders, anxiety. Fortunately, there are several options strategies that allow shareholders to protect their profits. The collar is a low-cost hedging strategy that can help nervous traders sleep peacefully at night.
More specifically, a collar combines purchasing a protective put and a selling a covered call on a stock the trader already owns. Selling the call helps fund the cost of entry for the protective put -- which can be a critical discount during earnings season, when options tend to be more expensive.
The purchased put strike should align with a price level that the trader believes is acceptable to sell the underlying shares. The covered call strike should line up with an overhead form of potential resistance, and at a level the trader would feel comfortable if the shares were called away. Let's look at an example:
Say a trader bought 100 shares of Stock XYZ at $90, and the stock is now trading at $100. Great! However, earnings season is approaching, and XYZ has a rather shaky history. The trader sees that the $105 level has stymied the security in the past. The nervous trader could then "collar" their XYZ shares, buying to open a 95-strike put, while selling to open a 105-strike call. The collar was established for a net debit.
If XYZ falls to $90 after earnings, the protective put in place gives the investor the right (not the obligation) to sell the stock at $95 -- more than what they'd get on the Street. As such, the trader would be locking in a profit on the initial XYZ share purchase, as opposed to if the collar had never established.
If the stock stays around $100, the investor would lose the initial net debit (the cost of the bought put minus the premium received from the sold call), which is the maximum risk. However, the collar isn't implemented to make money -- as with any insurance policy, it's there to help people rest a little easier.
If XYZ stock rallies to $110, the shares could then be called away for $105 apiece, due to the sold 105-strike call. Although it would be less than Wall Street value, the trader would still walk away with a decent profit from the initial XYZ shares, but would miss out on additional upside. Speculators uncomfortable with the idea of their shares being called away should consider a lone protective put.