Collar Option

A collar option, also known as a hedging collar or risk-reversal strategy, is a financial derivative strategy used to limit both potential losses and potential gains on an underlying asset. It involves holding a long position in the underlying asset while simultaneously purchasing a protective put option and selling a covered call option. The collar thus creates a price range—bounded by a floor price and a ceiling price—within which the investor’s returns are confined.
Collar options are widely used by investors and corporations seeking to hedge against adverse price movements in assets such as equities, commodities, or currencies while reducing the cost of protection.

Structure and Components of a Collar

A collar consists of three components executed simultaneously:

1. Long Position in the Underlying Asset: The investor owns the asset, such as shares of a company or a commodity.
2. Long Put Option (Protective Put): The investor buys a put option with a strike price below the current market price. This establishes a floor, protecting against downside losses beyond that strike price.
3. Short Call Option (Covered Call): The investor sells a call option with a strike price above the current market price. This creates a ceiling, limiting upside gains since the asset may be called away if the price exceeds this level.

The simultaneous sale of the call option helps offset the cost of purchasing the protective put, often resulting in a costless or zero-cost collar.

Example of a Collar Option

Suppose an investor owns 1,000 shares of a company currently trading at £100 per share.

• The investor buys a put option with a strike price of £90, paying a £2 premium per share.
• The investor sells a call option with a strike price of £110, receiving a £2 premium per share.

The net cost of the collar is therefore zero (a costless collar).

• If the share price falls below £90, the put guarantees that the investor can sell at £90, limiting losses.
• If the share price rises above £110, the investor must sell the shares at £110, capping potential gains.
• If the share price stays between £90 and £110, both options expire worthless, and the investor retains the shares.

This structure provides downside protection and upside limitation, stabilising returns within a defined range.

Purpose and Use of Collar Options

Collar options are primarily used for risk management and capital preservation. They allow investors to hedge against sharp price declines without paying the full cost of a protective put.
Common uses include:

• Equity Portfolio Protection: Limiting losses in a volatile stock or portfolio.
• Corporate Finance: Protecting the value of large equity holdings by company executives or founders.
• Commodity Hedging: Used by producers or consumers to stabilise prices of oil, metals, or agricultural products.
• Currency Risk Management: Employed by multinational corporations to hedge against foreign exchange fluctuations.

Types of Collar Strategies

While the basic collar structure remains consistent, variations exist depending on the investor’s objectives:

• Costless Collar: The premium received from the call option exactly offsets the cost of the put, making the hedge cost-neutral.
• Debit Collar: The cost of the put exceeds the call premium, requiring a net cash outflow.
• Credit Collar: The call premium exceeds the cost of the put, resulting in a small income but reducing downside protection.
• Dynamic Collar: The strike prices are adjusted periodically as market conditions change.

Payoff Structure

The payoff of a collar option can be represented graphically as a bounded range of returns:

• Below the put strike price, losses are capped because the investor can sell the asset at that level.
• Above the call strike price, gains are limited because the investor must sell the asset at the call strike.
• Between the two strike prices, the investor benefits from price movements within the range.

Mathematically, the profit or loss (Π\PiΠ) can be described as:
Π=ST−S0+C−P\Pi = S_T – S_0 + C – PΠ=ST​−S0​+C−P
where STS_TST​ is the terminal asset price, S0S_0S0​ is the initial price, CCC is the call premium received, and PPP is the put premium paid, subject to the floor and ceiling imposed by the option strikes.

Advantages of Collar Options

1. Downside Protection: The put option provides insurance against significant price drops.
2. Cost Efficiency: By selling a call, the investor offsets or eliminates the cost of buying the put.
3. Flexibility: Investors can select strike prices based on their risk tolerance and desired protection range.
4. Certainty of Outcomes: Defines a predictable profit and loss range, useful for conservative investors and corporate treasurers.
5. Hedging Without Liquidation: Allows investors to protect value without selling the underlying asset, which can be advantageous for tax or ownership reasons.

Disadvantages and Limitations

1. Limited Upside Potential: Gains above the call strike price are forfeited.
2. Potential Opportunity Cost: If the asset performs strongly, the investor misses out on additional profits.
3. Complexity in Selection: Choosing appropriate strike prices and expiration dates requires expertise.
4. Margin Requirements: Writing a call option may require margin posting, depending on the investor’s position and regulations.

Applications in Corporate and Institutional Contexts

• Executive Hedging: Company executives often use collars to lock in the value of their shareholdings without selling them outright. This helps manage wealth while avoiding potential insider trading issues.
• Mergers and Acquisitions: Collars are used in stock-for-stock deals to stabilise the exchange ratio when share prices fluctuate during negotiations.
• Commodity Producers: For example, an oil producer might use a collar to ensure it can sell crude oil at a minimum price while still participating in moderate price increases.
• Foreign Exchange Management: Corporations use FX collars to limit exchange rate exposure, setting a floor and ceiling for currency conversion rates.

Collar Options in Financial Markets

Collars are common in over-the-counter (OTC) markets, where they can be customised to suit specific risk profiles, and in exchange-traded options, where standardised contracts exist. Financial institutions often structure collars for clients as part of broader hedging programmes or structured notes.
In interest rate markets, a collar can refer to a strategy using interest rate caps and floors, designed to limit the effective interest rate within a defined range—commonly used in variable-rate loans.

Example of a Currency Collar

A UK-based exporter expects to receive €10 million in six months and wants to protect against euro depreciation. The exporter can:

• Buy a put option on EUR/GBP to guarantee a minimum exchange rate.
• Sell a call option at a higher rate to offset the put cost.