Equity and Index Options Explained

12

The Collar (Fence)

Option strategies often have a variety of names depending upon the specific market in which they are traded. “Collar” is prevalent in interest rate and forex markets, “fence” is typically used in commodities markets, “min/max” is often used in metals and LIFFE's official name for this strategy is a “combo”. Despite this, “collar” is the term that I am used to hearing in LIFFE's equity and index markets but all of the above terms may be used to describe this strategy. So what is a collar? A collar is an option strategy designed to protect an existing position in the underlying. Collars could be used in isolation but to do so would be highly risky. In order to understand how and why collars are used, it is worth revisiting the more basic ways in which derivatives in general may be used to protect underlying positions.

Consider a fund manager who invests in UK equities. Our fund manager is a “natural long” of UK shares. What does our fund manager, our natural long of equities, hope that the UK stock market will do? And what is his fear?

Clearly, our fund manager hopes that UK equities will rise in value and is fearful of a falling stock market. How could he hedge his long equity position? How could he protect his portfolio against a falling UK stock market? Given that our manager's exposure relates to the UK stock market, FTSE 100 Index derivatives might seem a sensible choice to hedge his basket of UK equities.

Derivatives, in this case FTSE 100 Index futures ...