UNDERSTANDING COLLARS FOR DEFINED-RISK HEDGING

A collar strategy is an options-based risk management approach that employs two complementary options positions to hedge a long stock position. Specifically, it involves selling a covered call option and buying a protective put option on the same underlying security. This structure provides downside protection while also limiting upside potential. Investors generally turn to collars when they wish to preserve capital in volatile markets while retaining ownership of the underlying asset.

The collar strategy is widely used by institutional and retail investors alike as a means of implementing a defined-risk hedge. By constructing a position with known maximum losses and gains, investors can better align their portfolios with risk tolerance and return expectations. The protective put offers a floor on potential losses, while the covered call generates income that can offset the premium cost of the put.

A standard collar consists of:

• Long stock position – the investor holds the underlying security.
• Long put option – bought below the current market price to limit downside loss.
• Short call option – sold above the current market price to generate premium income.

This configuration creates a 'collar' around the stock’s price, within which the investor experiences full exposure. Gains and losses are capped beyond the call and put strike prices, effectively defining the risk and reward profile of the position.

Collars are often used after a strong rally in a stock’s price, when investors seek to lock in gains while guarding against downturns. The strategy is especially prevalent in retirement accounts and for wealth preservation goals.

Historical Context and Institutional Use

Collars gained prominence during volatile periods such as the 2008 financial crisis and the 2020 COVID-19 selloff. Many institutional investors, including hedge funds, employ collars with customised strike placements to hedge large equity positions. These strategies also appear in structured products and defined-outcome ETFs.

By integrating both protective and income-generating elements, collars enable all-weather portfolio management, balancing opportunity and caution in uncertain markets.

At its core, a collar strategy aims to create a band around the potential outcomes of an investment over a defined time horizon. This band is dictated by the strike prices of the call and put options. For instance, an investor holding 100 shares of XYZ stock trading at £50 could implement a collar in the following way:

• Buy one XYZ 3-month £45 put – provides the right to sell the stock at £45, limiting downside risk to £5 per share.
• Sell one XYZ 3-month £55 call – obligates the investor to sell the stock at £55 if the market price exceeds that level, capping upside potential.

This construction defines a maximum loss of £5 per share (plus net option costs) and a maximum gain of £5 per share. Let’s take a closer look at the strategy’s components:

1. The Long Put Option

The protective put serves as insurance against a decline in the underlying asset’s value. It ensures that the investor can sell their shares at the put's strike price, regardless of how much the market price falls. The cost of this insurance is the put premium, which varies based on volatility, time to expiry, and moneyness.

2. The Short Call Option

The covered call generates premium income. The income reduces or offsets the cost of the protective put, making the collar a cost-effective hedge. However, the investor forfeits any gains above the call’s strike price. If the stock price exceeds the call strike at expiration, the shares will likely be called away.

3. Net Cost and Breakeven

The net cost of the collar depends on the difference between the call premium received and the put premium paid. In some scenarios, especially when call premiums are high, a collar can be established at zero cost or even a net credit.

Example: XYZ Collar Trade

Assume the investor pays £2 for the put and receives £2 for the call. The net cost is zero. The collar profile therefore defines:

• Maximum gain: £55 – £50 = £5 per share
• Maximum loss: £50 – £45 = £5 per share
• Breakeven price: £50 (stock purchase price)

Thus, no matter how volatile the market becomes, the investor knows the range of possible outcomes in advance. This predictability is the cornerstone of defined-risk investing.

Taxes and Assignment Risk

Investors should also consider the tax implications of exiting the underlying stock due to early call assignment. Additionally, dividend risk exists if the underlying stock pays dividends and the call is exercised early by the holder.

Ultimately, collars require active monitoring, especially if the stock approaches either strike price. Adjustments may be necessary as volatility, time decay, and market sentiment shift.

The collar strategy is not universally appropriate, but it can be extremely effective under specific circumstances. Whether working with individual stocks or broader equity portfolios, the key to using a collar successfully lies in timing, objective alignment, and risk tolerance.

Scenario 1: Locking in Gains

If a stock has experienced a strong run-up in price, investors may worry about a pullback. By deploying a collar, they can lock in a buffer around the existing market price. The collar limits further appreciation but provides downside protection without having to sell the shares outright.

Scenario 2: Nervous Markets

During times of elevated volatility or uncertainty (e.g., earnings season, geopolitical tensions, or pending central bank decisions), a collar can provide peace of mind. It allows investors to stay invested in equities while protecting against steep losses.

Scenario 3: Tax-Sensitive Portfolios

In jurisdictions where capital gains taxes apply, selling appreciated assets may trigger notable tax consequences. A collar enables investors to hedge risk without selling, thereby deferring taxable events while still protecting the portfolio.

Scenario 4: Low-Cost Hedging

When the income from a sold call can effectively pay for the protective put, the collar becomes a nearly costless hedge. These “zero-cost collars” are especially appealing to investors seeking risk mitigation without ongoing expenses.

Comparisons to Alternatives

Compared to outright puts, collars are more cost-efficient, because the premium paid for the put is subsidised by the call premium. While collars limit upside, they provide more balanced protection at a lower out-of-pocket cost than standalone puts.

Relative to stop-loss orders, collars provide protection without being triggered by gap-down moves or intraday volatility. Investors are not forced to sell during sharp but temporary downturns, thus preserving long-term investment theses.

Portfolio Applications

Institutions often overlay collars on major indices or ETFs using options to mitigate downside. For example, pension funds may use index collars to shield assets from crash risk. Similarly, high-net-worth individuals may collar concentrated equity positions to maintain holdings while limiting exposure.

Ultimately, collars appeal to cautious investors seeking both protection and discipline. By defining risk bands, aligning actions with long-term objectives, and smoothing returns, collars serve as a robust addition to the investor’s hedging toolkit.