Protective Collar Strategy
You want to make money in the stock market but you are a risk-averse investor; and don’t want to expose yourself to the potential of losing all of your money! Well, there’s a strategy for you which I will cover in this article.
If you want to make money in the Options market; but are afraid because of the associated downside associated with it; you can use the Protective Collar Strategy; it can provide protection against short-term losses, allowing you to make money when the market goes up.
Let’s say there’s a Stock X
Current Market Price (CMP): $180
Premium for 1-month $182 call = $0.60
Premium for 1-month $176 put = $0.40
Now, follow the below steps.
- Buy 10 shares of Stock X for $1800
- Sell 10 call options for $6 and Buy 10 put options for $4; Net Premium earned = $2
- At time of expiry:
- If price remains between $176 and $182 then you’ll earn $2 through the initial premium and keep holding the stock. So you have earned $2 without selling the stock.
- If the price goes above $182, let’s say $185, call option will be in-the-money (ITM); you’ll have to sell the share for $182 to the option-buyer. Since purchase price of the share was $180, you are in $2 profit per share; and total profit is $20 + $2 (initial premium) = Net profit of $22.
Important: If the investor didn’t go for a protective collar strategy; then he would make a higher profit in this scenario by simply selling the share for $185; and making a profit of $5 per share i.e. $50 profit. This strategy limits the profit potential for the investor to $22 no matter how high the market goes.
- If the price goes below $176, let’s say $150; put option will be ITM and you can sell the share to the option-seller at $176. No matter how low the share falls, your loss will be limited; since you can sell the share for $176 through the put option that you bought. Your loss in this case will be $4 per share; so total loss will be $40 – $2 (initial premium) = Net loss of $38.
Important: If the investor had not gone for a protective collar strategy; then he would incur a higher loss in this scenario; since the share price has gone down by $30 per share i.e. $300 loss. This strategy reduced the maximum loss of the investor to $38 no matter how low the market falls.
Protective Collar Strategy provides investors an opportunity to make money in the market when the market goes up; and at the same time protects them from huge losses in case of a fall in the stock price. Therefore, it’s a good strategy for risk averse investors who want to make money safely.
The downside of this strategy is that along with limiting the maximum loss; it also limits the maximum profit for an investor in case of a bullish market. So, it creates a collar or a boundary within which the investor can make a profit or a loss.
Do check out MKJ sir’s video on this topic at this link!
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