Options - Collar
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A collar position option collar payoff created by buying or owning stock and by simultaneously buying protective puts and selling covered calls on a share-for-share basis. Usually, the call and put are out of the money.
In the example, shares are purchased or ownedone out-of-the-money put is purchased and option collar payoff out-of-the-money call is sold. If the stock option collar payoff declines, the purchased put provides protection below the strike price until the expiration date.
If the stock price rises, profit potential is limited to the strike price of the covered call less commissions. Potential profit is limited because of the covered call. In the example above, profit potential is limited to 5. If selling the call and buying the put were transacted for a net debit or net costthen the maximum profit would be the strike price of the call minus the stock price and the net debit and commissions.
The maximum profit is achieved at expiration if the stock option collar payoff is at or above the strike price of the covered call. Short calls are generally assigned at expiration when the stock price is above the strike price. However, there is a possibility of early assignment. Potential risk is limited because of the protective put. In the example above, risk is limited to 4. If selling the call and buying the put were transacted for a net debit or net costthen the maximum profit would be the stock price minus the strike price of the put and the net debit and option collar payoff.
The maximum risk is realized if the stock price is at or below the strike price of the put at expiration. If such a stock price decline occurs, then the put can be exercised or sold. See the Strategy Discussion below. If a collar position is created when first acquiring shares, then a 2-part forecast is required.
First, the forecast must be neutral to bullish, which is the reason for buying the stock. Second, there must also be a reason for the desire to limit risk. Perhaps option collar payoff is a concern that the overall market might begin a decline and cause this stock to fall in tandem. Alternatively, if a collar is created to protect an existing stock holding, then there are two potential scenarios.
First, the short-term forecast could be bearish while the long-term forecast is bullish. In this case, the collar would leave in tack the possibility of a price rise to the target selling price and, at the same time, limit downside risk if the market were to reverse unexpectedly. Option collar payoff of a collar requires a clear statement of goals, forecasts and follow-up actions.
If a collar is option collar payoff when shares are initially acquired, then the goal should be to limit risk and to get some upside option collar payoff potential at the same time. Regarding follow-up action, the investor must have a plan for the stock being above the option collar payoff price of the covered call or below the strike price of the protective put.
If the stock price is above the strike price of the covered call, will the call be purchased to close and thereby leave the long stock position in place, or will the covered call be held until it is assigned and the stock sold? If a collar is established against previously-purchased stock when the short-term forecast is bearish and the long-term forecast is bullish, then it can be assumed that the stock is considered a long-term holding.
In this case, if the stock price is below the strike price of the put at expiration, then the put will be sold and the stock position will be held for the then hoped for rise in stock price. However, if the short-term bearish forecast does not materialize, then the covered call must be repurchased to close and eliminate the possibility of assignment.
However, if the stock price reverses to the downside below the strike price option collar payoff the put, then a decision must be made about the protective put. Will the put be sold and the stock kept in hopes of a rally back to the target selling price, or will the put be exercised and the stock sold?
The total value of a collar position stock price plus put price minus call price rises when the option collar payoff price rises and falls when the stock price falls. The net value of the short call and long put change in the opposite direction of the stock price.
When the stock price rises, the short call rises in price and loses money and option collar payoff long put decreases in price and loses money. The opposite happens when the stock price falls.
Options prices generally do not change dollar-for-dollar with changes in the price of the underlying stock. Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant.
Since a collar position has one long option put and one short option callthe net price of a collar changes very little when volatility changes.
This is known as time erosion. Since a collar option collar payoff has one long option put and one short option callthe sensitivity option collar payoff time erosion depends on the relationship of the stock price to the strike prices of the options. This happens because the short call is closest to the money and erodes faster than the long put.
This happens because the long put is now closer to the money and erodes faster than the short call. If the stock price is half-way between the strike prices, then time erosion has little option collar payoff on the net price of a collar, because both the short call and the long put erode at approximately the same rate. Stock options in the United States can be exercised on any business day. The holder long position of a stock option controls when the option will be exercised and the investor with a short option position has no control over when they will be required to fulfill the obligation.
While the long put lower strike in a collar option collar payoff has no risk of early assignment, the short call option collar payoff strike does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
Therefore, if the stock price is above the strike price of the short call in a collar, an assessment must be made if early assignment is likely. If assignment is deemed likely and if the investor does not want to sell the stock, then appropriate action must be taken. Before assignment occurs, the risk of assignment of a call can be eliminated by buying the short call to close. If option collar payoff assignment of a short call does occur, stock is sold. If a put is exercised or if a call is assigned, then stock is sold at the strike price of the option.
In the case of a collar position, exercise of the put or assignment of the call means that the owned stock is sold and replaced with cash. Therefore, if an investor with a collar position does not want to sell the stock when either the put or call is in the money, then the option at risk of being exercised or assigned must be closed prior to expiration. There are at least three tax considerations in the collar strategy, 1 the timing of the protective put purchase, 2 the strike price of the call, and 3 the time to expiration of the call.
Each of these can affect the holding period of the stock for tax purposes. As a result, the tax rate on the profit or loss from the stock might be affected. Investors should seek option collar payoff tax advice when calculating taxes on options transactions. If the stock is held for one year or more before it is sold, then long-term rates apply, regardless of whether the put was sold at a profit or loss or if it expired worthless. However, if a stock is owned for less than one year when a protective put is purchased, then the holding period of the stock starts over for tax purposes.
Option collar payoff a stock is owned for more than one year when a protective put is purchased, the holding period is not affected for tax purposes. When the stock is sold, the gain or loss is considered long-term regardless of whether the put is exercised, sold at a profit or loss or expires worthless.
A covered call position is created by buying or owning stock and selling option collar payoff options on a share-for-share basis. A protective put position is created by buying or owning stock and buying put options on a share-for-share basis. Reprinted with permission from CBOE. The statements and opinions expressed in option collar payoff article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies option collar payoff additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.
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