Options "Collar" strategy vs regular Profit/Loss stops

Question

I just found out about the option "collar" strategy which is implemented with a long put and a short call. My understanding is that a collar limits the profit as well as the loss on the underlying stock and if the premium for the put and call are about equal, there is no cost for the collar. So it appears to me that having collar around the underlying security is essentially the same as profit/loss stops.

Why would one choose to use "collar" versus profit/loss stops? Is it about slippage of P/L stops?

Answer 1

There are a few differences:

• profit/loss stops are triggered by a one-time event. So if the underlying stock has a large swing but returns to the original range, the collar will still be in play but with profit/loss triggers, you would have exited the position.
• collars expire at a point in time. if you are investing for the long-term you might need to "renew" your collar after expiry (possibly at different strikes), whereas limit/stop orders can be open ended.
• You have more flexibility with stop/limit orders without paying a premium. "Zero-cost" collars require that a certain ceiling be chosen for a given floor (or vice versa). This is to ensure that the premium paid for the long leg of the option is exactly offset by the premium received for the short leg. Of course, you can create a collar that pays you, but you'd have to either give up some upside potential or reduce your downside protection.
• Collars ensure the max and min are upheld. With limit orders, you enter in to a market trade after the threshold is breached, which might mean that you sell the stock for less than the minimum once the threshold is breached. Granted, the difference is likely small, but in a flash crash it could be significant.

Answer 2

Consider the capital requirement and risk time frame. With options, the capital requirement is far smaller than owning the underlying security. Options also allow one to constrain risk to a time frame of one's own choosing (the expiration date of the contract). If you own or are short the underlying security, there is no time horizon.

Answer 3

A stop loss order is used to buy or sell a security when it reaches a certain price (it can protect a long or a short position). Execution at that price is not guaranteed because the stock can gap up down, resulting in a fill much worse than the stop loss price.

In a long stock collar, for every 100 shares that you own, sell an out-of-the-money (OTM) call and use the proceeds to buy an OTM put. This defines a floor beneath which you cannot lose as well as a ceiling, beyond which you will not profit.

Collars can be structured for no cost. If you want to skew the risk graph so that you have more upside potential than downside risk, the call sold will be further OTM (or the put closer to the money) and the collar will have a net cost. Skewing the collar in the opposite manner (the put is more OTM than the call is OTM) will result in a net credit but potential loss will be greater than the potential profit.

A pending dividend affects option premium. Put premium will inflate and call premium will deflate. Therefore, the larger the dividend, the more expensive a collar becomes.

If you do 1-3 month collars and the stock appreciates toward the short call strike, you may be able to roll the collar up and/or out, protecting some of your capital gain. Wash, rinse, repeat.

Caveat? Don't monkey with collars if you don't want to sell the stock.

Collared long stock is synthetically equal to a vertical spread. That means that they have similar performance and similar risk graphs. For more info Google: “Synthetic Option Positions”