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The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website by Scott Nations

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CHAPTER 9

Collars

We saw in Chapter 4 that a covered call generates premium that we get to keep and that call premium provides a little downside protection. The downside protection isn’t infinite; it stops when the option premium received has been exhausted by the drop in the stock price. What if we wanted or needed more downside protection? We might think instead about buying a put option but we’d have to pay for that put option. If we sold a covered call and then used the premium received to buy that protective put, we could get the sort of protection we want but without paying much, if any, net premium. This combination of long stock, a covered call, and a long put is a collar. The two options will have the same expiration date but will have different strike prices, with the strike price of the covered call generally above at-the-money and certainly higher than the strike price of the protective put, which will generally be below at-the-money (if the options had the same strike price we would have constructed a conversion; see Chapter 13 for more on conversions).

Since a collar is short a covered call, there’s an upper limit to how high the underlying stock can rally before getting called away, meaning there’s an upper limit to the effective price we could receive for the stock and an upper limit to the value of the complete collared position. A collar is also long a protective put, so there’s a lower limit on how much we would receive for our stock and a lower limit to ...

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