Summary: With a normal collar you can lower your risk or lock in a profit. This option combination exists of long stock, a long put (right to sell) and a short call (potential obligation to deliver). Maximum profit and loss are known upfront. But there is even a smarter way to apply the concept of the collar. In this article is explained how.
Owning stock always bears the risk of declining prices. Is it possible to protect you from this? With options it is possible; the simplest way to achieve that would be buying a put option as protection for your individual stock position. Disadvantage is the (insurance) premium you have to pay. A way to decrease the investment is by selling a call at the same time. This limits the upside potential but does makes the initial investment of the protection lower. But is there a better way? Yes, there is, because you can apply the old saying: “Buy low, sell high” in a smarter way.
If you would compare the volatility level of an individual stock versus an index, in almost all cases the volatility of the individual stocks will be higher than that of the index. This means that the options premiums on the individual stocks are higher than in the index. So, how would it be if you sell the ‘expensive’ options (the calls on the individual shares) and at the same time buy the ‘cheap’ option (the puts on the index)?
If you have a portfolio consisting of several individual stocks, it is worthwhile to consider the following construction. Sell calls on the individual stocks and buy protection via puts on an index level. In other words, the basic concept of the collar applied in an intelligent way.
In that way you create still some upside potential in the individual stocks and at the same time you have created a portfolio insurance that protects your portfolio from the current level. It could easily be that the upside potential is 8% - 10% in the individual shares and the downside is 0% - 1% on a portfolio level.
An example with a portfolio consisting of 8 individual stocks (closing prices of Friday October 6 are used).
| Close October 6th | Call strike | Upside potential | Premium received Dec ’23 call | Premium as % of stock price | |
| Adobe | $527.00 | 580 | 10,1% | $12.00 | 2.30% |
| Alphabet | $138.00 | 155 | 12,3% | $1.86 | 1.30% |
| Apple | $177.00 | 195 | 10,2% | $1.64 | 0.90% |
| GE | $111.00 | 125 | 12,6% | $1.48 | 1.30% |
| Microsoft | $327.00 | 360 | 10,1% | $4.10 | 1.30% |
| Nvidia | $458.00 | 505 | 10,3% | $21.55 | 4.70% |
| Snowflake | $160.00 | 175 | 9,4% | $9.05 | 5.70% |
| Tesla | $260.00 | 285 | 9,6% | $3.70 | 5.30% |
| Average | 2.80% |
In the table above you will find big differences in the premium received for a 10% OTM call. It is all depending on the volatility of the underlying. But on average in this example it is 2,8%.
The S&P500 index is the one for buying downside protection. The normal S&P500 index options are ‘heavy’ options with an index around 4,300 and a contract size of 100. Therefor the options on the mini S&P500 will be used. This index trades at 1/10th of the price of the S&P500 index. The ticker to find these – cash settled – options is XSP.
The S&P500 index closed Friday the 6th of October at 4,308.50, so the 431 strike is the ATM put to buy if you want immediate protection. It traded at $10.20 at the close and that is 2.4% of the underlying.
By applying this strategy at these prices you have constructed downside protection that immediately starts working if the market declines. In case the stock market advances, there is 10% upside potential before you have to deliver the underlying as a result of the short call.There are some things that you have to take into consideration when you apply this strategy:
The most ideal scenario would be a slightly rising market. The stocks in your portfolio increase in value without the need to deliver any of them (due to the short call). A neutral scenario would be a market moving sideways where all the options expire worthless.
If a few of your (bigger) individual holdings will get hammered without causing any effect on an index level. As a result your portfolio will decrease in value and this is not offset by the long index puts.
In this construction this is hard to say because of the scenario where a few of your individual holdings are sharply decreasing in value. But on a portfolio level, the maximum loss is very limited because the insurance you bought immediately kicks in when the overall market declines.
An enhanced collar is not the simplest of option strategies. But the concept of ‘Sell high, buy low’ is applied in a clever way with this approach. Furthermore, this strategy is not applicable to all portfolios. The portfolio must be large enough, very well correlated to the corresponding index and very well diversified. But the end result is appealing: portfolio protection on the current index level and upside potential in the individual stocks.
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