Collar [1] is a financial term that refers to an option strategy that can limit the high and low returns on an underlying and keep it within a specific range.
Let us take for example an investor who owns a share of stock and the price of the stock is $10. The investor would put together a collar by purchasing one put that has a strike price of $8 and then sells one call that has a strike price of $12. This collar makes certain that the gain on his portfolio is no more than $2 and that any loss would not be more than $2. This is before you deduct the net cost of the put option [2] which is the put option minus what you receive for selling the call option [2].
When the option expires, there are three things that can possibly happen.
- If the stock price goes above the strike price then the person who bought it from the investor will exercise the purchased call. The investor must sell at the strike price and the locked in amount is what is provided to the investor. He only makes the specified amount.
- If the price goes below the strike price then the investor will exercise the put and the person who is selling it must buy it at the price at which it was set. The investor will only lose that specific amount and nothing more even if the price of the stock dips much lower.
- If the price of the stock hovers between the two strike prices and both option expire without being exercised then the investor must keep the share at that stock price including the cash that was gained from selling the call option but subtracting the price that was paid to purchase the put option.