Collar (finance)
Encyclopedia
In finance
, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying
to a specific range.
These latter two are a short Risk reversal
position. So:
The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. If the premium of the long call is exactly equal to the cost of the put, the strategy is known as a "zero cost collar". [Strictly speaking the name should be "zero premium collar" as the cost of holding the position can be potentially high if the price of the underlying rises above the strike level of the call.]
At expiration the value (but not the profit) of the collar will be:
The maximum value occurs for any price of the underlying above X+a.
with a current share
price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option, i.e., the cost of the put option less what is received for selling the call option).
There are three possible scenarios when the options expire
:
One source of risk is counterparty risk. If the stock price expires below the $3 floor then the counterparty may default on the put contract, thus creating the potential for losses up to the full value of the stock (plus fees).
Now she can face 3 scenarios:
, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction cost
s associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?
If it makes more sense to hold onto the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free.The price received for selling the call is used to buy the put—one pays for the other.
Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return
, that expected return is only the mean
of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
to a specific range.
Structure
A collar is created by an investor being:- LongLong (finance)In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
the underlying - long a put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
at strike priceStrike priceIn options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
X (called the "floor") - Short a call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
at strike price (X+a) (called the "cap")
These latter two are a short Risk reversal
Risk reversal
-Risk Reversal investment strategy:A risk-reversal consists of being long an out of the money call and being short an out of the money put, both with the same maturity....
position. So:
- Underlying - Risk reversalRisk reversal-Risk Reversal investment strategy:A risk-reversal consists of being long an out of the money call and being short an out of the money put, both with the same maturity....
= Collar
The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. If the premium of the long call is exactly equal to the cost of the put, the strategy is known as a "zero cost collar". [Strictly speaking the name should be "zero premium collar" as the cost of holding the position can be potentially high if the price of the underlying rises above the strike level of the call.]
At expiration the value (but not the profit) of the collar will be:
- zero if the price of the underlying is below X
- positive if the price of the underlying is between X and (X + a)
The maximum value occurs for any price of the underlying above X+a.
Example
Consider an investor who owns one hundred shares of a stockStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
with a current share
Share (finance)
A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
price of $5. An investor could construct a collar by buying one put with a strike price of $3 and selling one call with a strike price of $7. The collar would ensure that the gain on the portfolio will be no higher than $2 and the loss will be no worse than $2 (before deducting the net cost of the put option, i.e., the cost of the put option less what is received for selling the call option).
There are three possible scenarios when the options expire
Expiration (options)
For an option contract, expiration is the date on which the contract expires. The option holder must elect to exercise the option or allow it to expire worthless.Typically, option contracts expire according to a pre-determined calendar. For instance, for U.S...
:
- If the stock price is above the $7 strike price on the call he wrote, the person who bought the call from the investor will exerciseExercise (options)The owner of an option contract may exercise it, indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties, and the contract itself is terminated...
the purchased call; the investor effectively sells the shares at the $7 strike price. This would lock in a $2 profit for the investor. He only makes a $2 profit (minus fees), no matter how high the share price goes. For example, if the stock price goes up to $9, the buyer of the call will exercise the option and the investor will sell the shares that he bought at $5 for $9, for a $4 profit, but must then pay out $9-$7=$2, making his profit only $2. - If the stock price drops below the $3 strike price on the put then the investor may exercise the put and the person who sold it is forced to buy the investor's 100 shares at $3. The investor loses $2 on the stock, but can only lose $2 (plus fees), no matter how low the price of the stock goes. For example, if the stock price falls to $1, then the investor exercises the put and has a $2 gain. The value of the investor's stock has fallen by $5-$1 = $4. The call expires worthless (since the buyer does not exercise it), and the total net loss is $2-$4= -$2.
- If the stock price is between the two strike prices at the expiration date, both options expire unexercised, and the investor is left with the 100 shares whose value is that stock price (x100), plus the cash gained from selling the call option, minus the price paid to buy the put option, minus fees.
One source of risk is counterparty risk. If the stock price expires below the $3 floor then the counterparty may default on the put contract, thus creating the potential for losses up to the full value of the stock (plus fees).
Structure
In an interest rate collar, the investor seeks to limit exposure to changing interest rates and at the same time lower its net premium obligations. Hence, the investor goes long on the cap (floor) that will save it money for a strike of X +(-) S1 but at the same time shorts a floor (cap) for a strike of X +(-) S2 so that the premium of one at least partially offsets the premium of the other. Here S1 is the maximum tolerable unfavorable change in payable interest rate and S2 is the maximum benefit of a favorable move in interest rates.Example
Consider an investor A who has an obligation to pay floating 6 month LIBOR annually on a notional N and which (when invested) earns 6%. A rise in LIBOR above 6% will hurt the investor while a drop will benefit her. Thus it is desirable for her to purchase an interest rate cap which will pay her back if the LIBOR rises above her level of comfort. Figuring that she is comfortable paying upto 7%, she enters into an Interest Rate Cap with counterparty B wherein B will pay her the difference between 6 mo LIBOR and 7% when the LIBOR exceeds 7% for a premium of 0.08*N. To offset this premium, she sells an Interest Rate Floor to counterparty C wherein she will pay them the difference between 6 mo LIBOR and 5% when the LIBOR falls below 5%. For this she receives 0.075*N premium, thus offsetting what she paid for the Cap.Now she can face 3 scenarios:
- Rising interest rates - she will pay a maximum of 7% on her original obligation. Anything over and above that will be offset by the payments she will receive from party B under the Cap agreement. Hence A is not exposed to interest rate rises of more than 1%.
- Stationary interest rates - as long as the LIBOR stays around 6%, A is not affected.
- Falling interest rates - she will benefit from a fall in interest rates upto a limit of 5% as per the floor agreement. If it falls further, A will make payments to C under the Floor agreement while saving the same amount on the original obligation. Hence A cannot benefit from a fall of more than 1%.
Why do this?
In times of high volatilityVolatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
s associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?
If it makes more sense to hold onto the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free.The price received for selling the call is used to buy the put—one pays for the other.
Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return
Expected return
The expected return is the weighted-average outcome in gambling, probability theory, economics or finance.It isthe average of a probability distribution of possible returns, calculated by using the following formula:...
, that expected return is only the mean
Mean
In statistics, mean has two related meanings:* the arithmetic mean .* the expected value of a random variable, which is also called the population mean....
of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.