Moneyzine
Contents
/Investment Guides /Protective Index Collars

Protective Index Collars

Moneyzine Editor
Author: 
Moneyzine Editor
4 mins
November 6th, 2024
Advertiser Disclosure

Definition

The term protective index collar refers to the investment strategy of simultaneously purchasing a put option and writing a call option. Protective index collars are used by investors to limit the downside risk of a portfolio they own.

Explanation

While a protective index collar can help reduce the downside risk of an investor's portfolio, they also limit its upside potential. Index collars are of interest to individuals that own a portfolio of securities that closely track the performance of an index. This strategy involves the purchase of a put to limit downside risk and the selling of a call that limits upside potential. Index collars may be constructed such that the price received for writing the call option exceeds the price paid for the put. Using this strategy, the investor effectively receives free "insurance" provided by the protective put option.

When constructing the collar, the strike price on the put becomes the floor price for the index while the call's strike price places a cap on profits. Both options will typically have the same expiration date and will be initially out-of-the-money. One put option is purchased and one call option is written for every 100 shares of the index the investor wishes to protect, which should correspond with the dollar value of the investor's portfolio they wish to insure.

Investors interested in protective index collars should keep in mind that American options allow for assignment at any time before the contract's expiration date, while European options allow for assignment typically the day before the contract expires. Finally, index options are always cash-settled.

Example

An investor possesses a portfolio of technology stocks valued at $5,000,000 and the performance of that portfolio closely matches the performance of Index ABC, which currently trades at $5,000. To protect the unrealized gain on the technology stocks, the investor purchases a number of collar options, calculated as:

= Value of Portfolio to be Protected / (Index Value x Multiplier)= $5,000,000 / ($5,000 x 100)= 10 collars

In this example, the investor's collar would consist of 10 puts and 10 calls on Index ABC, with an expiration of 90 days. The investor decides to purchase a put with a strike price that is 6% below Index ABC's current trading price, or $4,700, so the put purchased is 90-day ABC $4,700. At the same time, the investor sells 10 call options, 90-day ABC $5,300. The price of the put option is $30.00, or $3,000 per option, while the selling price of the call option was $28.00, or $2,800 per option. In this example, the net cost of each collar is $3,000 - $2,800, or $200. There are three possible outcomes at expiration.

Index Price Declines

If Index ABC trades at $4,500, the investor's put will be in-the-money and they have a right to settle their position in cash for $4,700 (strike price) - $4,500 (index price) x 100 multiplier, or $20,000 per put. Under these conditions, the investor would receive a total of $20,000 per put x 10 options, or $200,000. The call options expire out-of-the-money. While it may seem like a windfall for the investor, keep in mind the value received from the put is used to offset the loss on the investor's portfolio. Assuming the value of the portfolio tracked well with Index ABC, the portfolio would be worth $4,500,000 + $200,000 cash settlement, or $4,700,000.

Index Price Increases

If Index ABC trades at $5,500, the investor's call will be in-the-money. They will be assigned and obligated to settle their position in cash for $5,500 (index price) - $5,300 (strike price) x 100 multiplier, or $20,000 per call. Under these conditions, the investor would be required to settle their 10 options for $200,000. The put options expire out-of-the-money. While it may seem like the investor realized a large loss, keep in mind the increase in the investor's technology portfolio can be used to offset the loss on the call option. Assuming the value of the portfolio tracked well with Index ABC, the portfolio would be worth $5,500,000 - $200,000 cash settlement, or $5,300,000.

Index Price Falls Between Contracts

If Index ABC stock trades between $5,300 and $4,700, both options expire out-of-the-money. Under these conditions, the investor realizes a loss of $200 x 10 collars, or $2,000, associated with the net cost of the options.

Related Terms

equity collars, equity LEAPS puts, equity LEAPS calls, index calls

Explore Investing Further

  • Trading has never been easier, thanks to the rise of online platforms that enable you to buy and sell various assets at the click of a button. But with so many options available, it can be challenging to decide which platform is right for you.
  • Looking for a way to avoid swap fees while trading forex?
  • By providing instant diversification for your portfolio, investing in ETFs can amplify the potential of any investor, novice or seasoned alike. We scoped the market to curate a list of the best ETF trading platforms available for US investors.
  • Our top beginner's pick for copy trading is eToro. Read on for more details, plus seven good alternatives.
  • Swing trading stocks can be a great way for investors to take advantage of short-term stock market movements and gain significant returns. If you're interested in swing trading, the key to success lies in selecting the right stocks to buy and sell quickly for a profit.
  • The table below lists the best stock picks under $2, listed on public exchanges.
  • The table below lists the best stock picks under $1, listed both on public and OTC exchanges.
  • This section will highlight the best EV-trading penny stocks available in the United States.
  • The demand for sustainable energy has grown rapidly in recent years. This has resulted in increased scrutiny of the automotive market. As a result, the electric vehicle (EV) industry has made significant advancements.
  • Intelligent Bio Solutions Inc. is a life sciences company, founded in 2016 with headquarters in New York and is engaged in performing diagnostic tests, real-time monitoring, and non-invasive surgery for its patients. The firm has developed a CoV-2 Biosensor, which can be used in RNA virus detection.
  • Hour Loop was founded in 2013 with headquarters in Redmond, Washington. It’s an online retailer involved in e-commerce in the United States that hit the public markets on Jan 7th of 2022. The company sells home/garden decor, electronic products, kitchenware, and apparel through walmart.com, amazon.com, and hourloop.com.

Related Content

  • Biden Or Trump: Who Is Better For The Economy And Stocks?
    Yup. This is one of those articles. It's an election year, and here in the U.S., we get to decide which old dude who’s been alive long enough to remember when there were only 48 states in the U.S. will be the leader of the free world.
    March 19th, 2024
  • When it comes to strategic business planning, accounting is front and center, shaping the course of action. At least it should be.
    March 14th, 2024
  • How To Invest in Real Estate Without Becoming a Landlord
    We all know that in order to build wealth and prepare for retirement, investing is the key. However, it can be hard to figure out what to invest in and how to put your money to good use. One of the most talked about ways to build wealth is owning property and being a landlord to bring in passive income. But what if you don’t want to do that? You can still invest in real estate!
    November 15th, 2024
  • Investing In Nature: The Closest You'll Get To Your Money Growing On Trees
    ESG (Environmental, Social, and Governance) has become a polluted word for many traders and investors - but that doesn't mean it's going completely away. Nor does that mean you can't profit from nature or sustainable practices. But there are some opportunities in the regenerative ag, conservation, and green real estate spaces.
    February 29th, 2024
  • How to Invest $100 and Grow it to 6 Figures
    Turning $100 into six figures is a goal no one should realistically have. But it's the question you might ask yourself: Can it be done? Sure. Probable? It's less probable than winning the lottery, but technically still probable - like finding a needle in a haystack the size of Canada. But possible? Absolutely.
    October 29th, 2024

Contributors

Moneyzine Editor
The Moneyzine editorial team consists of writers and content specialists with diverse backgrounds.
Moneyzine 2024. All Rights Reserved.