Option Basics -- IV

Anup Menon

This week we shall look at an option strategy known as collars.

Assume you are an investor and want to own the stock of ABC company. You also know that the stock is not likely to move up at a rapid pace and you want to limit your downside. Under these conditions, an investor can consider using a collar strategy. A collar strategy involves three distinct transactions, namely the purchase of the asset in the spot market. purchase of an out-of-the-money put option and sale of an out-of-the-money call option. The potential risk and reward from using this strategy is limited.

Normally investors using this strategy try to even out the cash outflow on buying the put with the cash inflow from selling the call. In other words the premium paid for the buying the put and selling the call will be equal. This effectively means that the cost incurred by the investor is the equal to that of buying the stock in the spot market. An example would make the operation clearer.

Assume that the stock of ABC is selling at Rs 100. The investor purchases 10 shares of ABC, which means a net outflow of Rs 1,000 (for the purchase in spot market). At the same time the investor also purchases 1 put option (10 shares) with strike price at Rs 95. The investor also sells 1 call option (10 shares) with a strike of Rs 110. Since the premium paid for the put option is the same as the premium received for the call option, the net cost for the investor is Rs 1,000 only.

Assume that the stock price moves down to Rs 90. In that case three events happen. Firstly the call option is worthless. The investor will exercise his put option and thereby receives a cash inflow of Rs 50. The spot position incurs a loss of Rs 100. Therefore, the maximum loss that an investor will suffer is Rs 50. The same condition holds true for any combination of the spot price. If the asset price falls below the put strike, then the maximum loss that the investor can suffer is the difference between the put strike and initial spot price.

Similarly assume that the price of the asset rises to Rs 120. Then the put option is worthless. The investor will have to provides the shares at Rs 110. This means that he will lose Rs 100 (10*10) in the process. However the spot position will gain by around Rs 200. Therefore the net gain will always be Rs 100, that is the difference between the call strike and the original asset price.

Hence we can see that while the risks are contained, the rewards are also constrained.