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In Part 1 of this series on options strategy, John Jagerson discussed how to use a collar option to navigate the volatile markets. You can read part 1 of "How to use Option Collars in Volatile Markets", by clicking here.
In this article, we will walk through the process and potential end results of buying a collar on a long stock position. In the market, the more you reduce your risk the more you reduce your upside and a collar is a great example of that principle.
The structure of a collar consists of selling an out of the money call to finance the purchase of a protective put. Although the premium from the call will help to offset the cost of the protective it will cap your gains.
By expiration there are three possible results. The first possibility is that the market rises considerably and you are called out at the strike price of the call you sold. Your gains are offset slightly by the cost of the collar.
The second possibility is that the stock or market falls a lot and you start to lose money on the stock but the put becomes more profitable limiting those losses. Keep in mind as well that in the second scenario you get to keep the premium from the covered call you sold. In the final scenario the market does not move by very much and you are not called out and the put expires worthless. In this case, you will have likely lost a little but have probably enjoyed your peace of mind.
A collar is usually only bought against a stock that you own and don't want to sell at current prices but would be willing to sell if you had some minor price improvement. Traders use them when they have a bullish bias on the stock but may be concerned about short term volatility to the downside.
You will see this strategy used during periods of extreme market volatility as well as before corporate events like an announcement or earnings release. Run an "if-then" analysis of your own on some stocks that you are holding to see if this strategy makes sense for you.
John Jagerson is the author of many investing books and is a co-founder of LearningMarkets.com and ProfitingWithForex.com. His articles are regularly featured on online investing publications across the web.
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