Are collars really downside protection?
I see collars often mentioned as downside protection for a stock you own. My question is: How?
Let's say you bought at stock at 45 and it is now 50. You can collar the 45 cost basis (one strike above 45 and one below). This is considered downside protection.
Now the stock moves down to 45. Then continues to 39, 37, 35. The collar expires. The stock is now 34. Where's the downside protection? Even if the collar is still on, where is the downside protection?
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Where's the protection?
If you buy a stock for and it drops to by expiration, the loss is 30 points.
If you buy a stock for and you execute a 45p/55c no cost long stock collar, the loss is only 5 points at expiration.
If you want more protection or a higher reward potential, you can shift the risk graph by selecting strikes that are not equidistant away from share price. This will result in some amount of debit to put on the collar.
Prior to expiration, as the underlying drops, the put increases in price and the call decreases in price. As a hypothetical example, if these were 30 IV options and the stock dropped immediately, the net loss might be only 3 points at . The higher the IV, the less the loss would be. The closer you are to expiration, the lower this mitigating factor would be.
If the underlying collapses below the long put strike and IF you still want to own the underlying, you could roll the options down, lowering your cost basis. This will add more potential loss but will lower your upside break even price.
Note that long collared stock is synthetically equivalent to a vertical call spread so if opening all 3 legs simultaneously, consider the 2 legged critter to potentially reduce commissions and B/A damage.
The stock is currently at 50.
Write a covered call at a strike price of 55. Use the money received from the covered-call-write to buy a put at a strike price of 45.
The position keeps the upside to a stock price of 55 but has no more upside beyond 55. Or the position will have gain on the put at anything less than 45 which is the downside protection.
Options are for a limited amount of time.
If you have a put option, you can choose to sell at its strike price (this is called exercising the option) rather than the stock's market price.
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