Collar Options: The Basics

Although there are many ways to trade stocks, collar options tend to provide a way to stay in a trade longer with less risk. This is not necessarily the best trade for every situation but just an alternate approach.

When setting up a collar options trade, three things are needed. First, 100 shares of a stock. Stock selection can be done in many ways whether it is fundamental or technical analysis, word of mouth, or picking something from a hat. The next thing needed are two option trades. One will be to buy a put option (preferably near your stock price) and the second will be to sell a call option (preferably to where you think the stock may go).

As a small recap on options, when you purchase a put contract, you have the right to sell the shares of the stock at the chosen strike price. This is a right and does not have to be exercised. When a call option is sold, then you have an obligation to sell your shares at the chosen strike price. Although adjustments to the trade can be made, if the stock goes in the money (ITM) of the call option, then it could be taken away (called away) at some point (although usually happens near expiration).

The combination of these two options is usually a debit and will add to your cost basis. The overall trade caps the downside as well as the upside. The downside risk can be adjusted to your own tolerance. It can be a bit tricky if the stock moves too much in your favor. Whether or not the trade works out, the options can be rolled if you want to continue holding the position.