Option Collars: A Low Cost Way to Protect Your Dividend Stocks

Option collars offer buy-and-hold dividend investors a low cost way to protect their portfolio from losses. This strategy combines two options strategies: the covered call and the protective put. The option collar potentially limits your profit since the stock will be called away if it rises above the call strike price.

There is limited loss because of the protective put protects your down side.

Why would an investor want to limit the profit and loss potential on a stock position with an option collar?

One answer is the investor has reason to believe he or she is facing an imminent drop in price and needs to protect against it, but doesn’t want to pay full price for a protective put.

Investors typically do not have option collars in place all the time. The investor instead places a option collars around stocks when he or she is concerned about upcoming downward volatility and either wants to lock in a profit, or wants to limit losses if the stock price drops. For example, earnings season, anticipation of a news release, technical signals indicating possible future stock market volatility.

Since the investor is more inclined to place a collar around a stock that is at risk of a price drop the investor probably believes that chances of continued upward price movement is less than sideways or downward movement. The investor therefore believes that the stock has less chance of being called which makes the “limited profit” less of a concern.

Here ‘s how it works:

Let’s say you own a dividend stock. You decide that you want to protect this position from a loss.

1. You sell covered calls against the stock. The call sold is out of the money.

   The call strike price depends on how much credit you want to offset the cost of the protective put, and how much buffer you want to prevent the call from being exercised.

2. You buy put options to protect against a price drop. The put option strike price is selected based on your risk tolerance and how much you are willing to pay for the protection.

You will continue to collect dividends on the stock unless, of course, the stock rises above the call strike price and the call is exercised. If this were to happen the profit is the dividends collected, plus the capital gain (call strike price minus your cost per share), minus the debit to establish the collar.

The option collar holder has two options if the stock price falls below the put strike price:

1. You can exercise your put option which will result in the stock being sold at the put option strike price.

   The result of this action may be a gain or loss depending on the cost basis for the stock. If the cost basis is below the put strike price the investor will have a profit. If the cost basis is above the strike price the loss is limited to the difference between the stock purchase price and the put strike price (minus dividends you’ve received).

   This course of action is preferred if the stock price dropped due to a fundamental change to the stock, like a reduction in its dividend, making further stock ownership undesirable.

2. You may choose instead to sell the put option contract since it will have gained intrinsic value if you desire to continue owning the stock. For example, the stock’s fundamentals remain unchanged and the stock price fell due to broad market selling. Selling the put option before expiration will provide cash to invest more money into that stock or allow you to invest in other opportunities.

My Preferred Strategy To Protect My Portfolio

Each options investor must choose a strategy that is consistent with risk tolerance and investment goals.

I prefer to employ strategies that minimize my cost, limit my downside risk, but avoids limiting my potential gains to the maximum extent possible.

You can learn learn about how I successfully hedge my portfolio and avoid stock market losses by CLICKING HERE

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