Covered Call Collar

Purpose of the Covered Call Collar

The purpose of the covered call collar is relatively straightforward; it's to try and profit from a long stock position (i.e. stocks that you own) that you don’t believe is going to increase much in value, if at all, in a specific time frame. Rather than exiting your position and then using your capital to invest elsewhere, you can use this strategy to generate a return from your stock maintaining a stable price.

It's a direct extension of the covered call, which is used the same purpose, but sacrifices some of the profitability of that strategy to also hedge against the stock falling in value. Therefore you would use it when you wanted to earn money from your neutral outlook, but you wanted some protection against potential losses if the stock price dropped.

Applying a Covered Call Collar

In theory you can create a covered call collar entirely from scratch, buying the stock first and then carrying out the necessary options trades. This isn't necessarily the best way to try and profit from a neutral outlook though, because of all the commissions involved, and there are a range of strategies that can be constructed entirely using options.

The covered call collar is typically used when you already own stock. For the purposes of this article, we will work on the premise that you already have a long stock position and are looking to use this strategy to generate a return from that position remaining relatively stable in price.

Putting the strategy into place is straightforward enough, with just two transactions required. You would write calls on the relevant stock (enough to cover the amount of shares owned) using the sell to open order and buy the same amount of puts using the buy to open order. You should use the same expiration date for both sets of options, which would typically be the nearest expiration date. You can, however, use a longer term expiration date if you believe the stock will remain stable for a longer period of time.

The big decision you need to make when establishing the covered call collar which strikes to use. Generally speaking, you should write out of the money calls at a strike that is only slightly higher than the current price of the stock you own. You can use an even higher strike if you wish, because this will enable you to potentially make more profits if the stock increases in price, but you will receive a lower credit and will make less if the price doesn't go up.

The puts that you buy should also be out of the money, and you need to spend less on them than you receive for writing the calls. Below is an example of how you might apply this strategy.

• You own 100 shares of Company X stock, which is currently trading at $50. We shall refer to this price as the Starting Point.
• You believe that the price will not move much, if at all, over the next few weeks and you want to try and profit from that.
• Out of the money calls with a strike of $52 and the closest expiration date are trading at $1. You write 1 call options contract (each contract contains 100 options) and receive a credit of $100. This is Leg A.
• Out of the money puts with a strike of $47 and the closest expiration date are trading at $.50. You buy 1 call options contract (each contract contains 100 options) at a cost of $50.
• You have created a covered call collar and received a net credit of $50.

Potential Profits

The maximum possible profit will be returned when, at the time of expiration, the price of the stock has increased to the strike of the calls written ($52 in the case of the example provided above). When this happens, the calls you have written will be at the money, and will therefore expire worthless. The puts you have bought will also expire worthless.

Therefore, you would keep the net credit made at the time of applying the strategy ($50). Because the shares that you own have increased in value, at the rate of $2 per share, you will have also made a profit of $200 on them. This would give you a total profit of $250.

You would also make a profit if the price of the shares remained exactly the same, or increased to a point lower than the strike of the options written. Once again, you would keep the net credit made, because the calls written and the puts bought would all expire worthless. If there was an increase in the value of the shares, that would also represent a profit.

The potential profits can be shown as follows.

• Maximum profit is made when “Price of Underlying Stock = Strike of Options in Leg A”
• Profit is also made when “Price of Underlying Stock > or = Starting Point but < Strike of Options in Leg A”
• Profit, per share owned, is “(Price of Underlying Stock – Starting Point) + (Price per Option in Leg A – Less Price Per Option in Leg B)”
• This profit calculation does not apply should “Price of Underlying Stock > Strike of Options in Leg A”

There's an argument that suggests that any profits made from an increase in the price of the underlying security shouldn't be included in the profit calculations, because those profits would be made from owning the security regardless of whether the covered call collar is applied or not.

Risks

The biggest possible loss occurs if the price of the underlying security should drop to exactly the strike of the puts options bought in Leg B ($47 in this case). The calls would expire worthless, and so would the puts, so you would keep the net credit.

However, the shares you own would have dropped in value (by a total of $300 in this example), and that loss wouldn't be completely covered by that net credit. If the shares drop even further, then the losses wouldn't get any greater. Although the stock would continue to fall in value, the puts would start to increase in value and offset that fall. The potential losses can be summarized as follows.

• Maximum loss is made when “Price of Underlying Stock = Strike of Options in Leg B”
• Maximum loss, per share owned, is “(Starting Point –Strike of Options in Leg B) - (Price per Option in Leg A – Less Price Per Option in Leg B)”

There's also the risk that the covered call collar can potentially cost you profits, if the stock rises above the strike of the options written in Leg A. In the above example, should the stock rise above $52, then the calls written in Leg A could be assigned. You could be obliged to sell the stocks you own at the strike of $52.

This would still represent a profit, but you could have made a larger profit if you had just kept hold of your stock and not used this strategy. Although you can always close the short options position created in Leg A (by using the buy to close order to buy the options back), this is by no means an ideal strategy to use if you think there is a chance that the underlying security will increase significantly in price.

Summary

This is a safe strategy to use if you believe that stock you own is likely to remain roughly the same price for a period of time. You do limit your potential profits if the stock price should increase dramatically, but you also limit your losses should it drop dramatically. You'll make maximum profit if the stock price fails to move or increases just a little.

One key advantage of the covered call collar is that, at the time of applying the strategy, you can calculate exactly what the maximum return and the maximum loss might be.