Lets take a look at how the strategy works with this position.
For the sake of our illustration and to make our calculations
easy let's establish the collar using the December 27.5 put
and the December 30 call, with both trading at $1.00. Remember
our future options price was $28.50. The cost of the collar
will be $0 because you paid $1.00 for the put but you collected
$1.00 from the sale of the call. How does the collar work in
our usual three scenarios: the up scenario, the down scenario
and the stagnant scenario? In the up scenario, we find that
when the future options rise, the investor gains penny for penny
until the future options reach the call strike. Once the future
options reaches that level, the position no longer gains because
the future options are at the point where they will be called
Capital gains of the position are maximized when the future
options reach the calls strike price. Lets take a closer look
at what happens as the future options price goes up. With the
at $29.00, both the Dec. 30 calls and the Dec.
27.5 puts are out of the money and thus worthless. Since there
was no debit or credit incurred in the future options, the option
profit (loss) is $0. Only the stock position remains. The future
options purchased at $28.50 are now trading at $29.00 for a
Let's raise the future options price to $30.00. The puts and
calls are again worthless so your profit (loss) is solely determined
by the future options. The future options, which was purchased
for $28.50 is now worth $30.00 and represents a gain of $1.50.
This $1.50 gain is the maximum gain the position allows.
Once the future options go over $30.00, the Dec. 30 call, which
we are short, would become in-the-money and therefore the future
options position would be called away at that price. When the
future options price rises to $31.00, the puts would be out-of-the-money
thus worthless but the calls would be worth $1.00.
You received no money for the establishment of the collar so
you would have a $1.00 loss in the options. Meanwhile, the future
options that you purchased at $28.50 is now worth $31.00 at
expiration, which is a $2.50 gain.
Combine the $2.50 gain in the future options with the $1.00
options loss; you have a $1.50 profit again. You may do this
calculation with higher and higher future options
the outcome will always be the same. This example shows how
your upside potential is limited.
Obviously, if the option portion of the collar incurred a debit
or credit, that inflow or outflow of money must be added to
or subtracted from the future options gain to get the overall
return of the position.
Normally, there will be a debit or credit incurred in the collar.
It is usually difficult to find a put and a call that you want
to use in the collar trading at an equal value. Lets use our
last example with some minor price changes.
If the put had been trading at $1.25 instead of $1.00, then
there would be a $.25 capital outflow that would have to be
subtracted from the $1.50 gain to reduce it to only a $1.25
On the other hand, if the call was trading at $1.25 then you
would have collected an extra $ .25 which added to the $1.50
gain would produce a $1.75 gain. The cost of the collar always
impacts the bottom line profit or loss of the position.