Many investors see options trading as little more than a way to add speculative leverage to their portfolios.
But the fact is, options can help generate yield from existing positions (through selling covered calls, for instance) and they can help you insure your portfolio against loss.
And using those two strategies together can help you do a little bit of both. In essence, you use the yield you generate from selling calls to pay for the insurance that will help protect your profits.
The strategy I want to discuss today is known as a collar, and the strategy’s goal is to preserve hard-earned capital while simultaneously allowing a position to continue making profits.
Unfortunately, greed often deters individual investors from using collars. Hedge funds and even large institutional managers frequently use collars, so why aren’t most individual investors using this safe, protective options strategy?
It’s because most investors don’t realize that collars not only protect their unrealized profits, they also allow you to hold a position that you don’t want to sell but for which you want some downside protection just in case the stock takes a fall. Think earnings surprises, or if you own a stock that pays a healthy dividend that you want to keep holding through what you feel is a correction phase for the market. Or maybe investors simply don’t realize they are one of the cheapest, yet most effective ways to reduce risk.
It doesn’t really matter the reason; it only matters that you’re aware of this strategy to keep risk in hand. Because the most important aspect of successful, long-term options investing is a disciplined approach to risk management. Without it, even the best strategies are inevitably doomed.
[text_ad]
A collar is an options strategy that requires an investor, who already owns at least 100 shares of a stock, to purchase an out-of-the-money put option and sell an out-of-the-money call option.
Think about it as a covered call coupled with a long put.
1. Long Stock (at least 100 shares).
2. Sell call option to finance the purchase of the protective put.
3. Buy put option to hedge downside risk.
Collar Option Strategy = long stock + out-of-the-money long put + out-of-the-money short call
You can actually finance most of your protection, so the cost of a collar is limited, if not free. Again, this is why intelligent investors and professional traders use collars habitually.
I’m going to use the heavily traded S&P 500 ETF (SPY) for my example, but you can apply this technique to any stock or ETF in your portfolio.
Let’s say we own 100 shares of SPY and would like to protect our return going forward. We still want to hold the ETF and participate in further upside. But we also realize that the ETF has had an incredible run and want some downside protection, specifically over the short term.
The ETF is currently trading for 697.51.
1. With SPY currently trading for 697.51, we want to sell an out-of-the-money call as our first step in using a collar option strategy.
A good place to start is with a call that has roughly 30-60 days left until expiration. So, to keep things simple, I am going with the May 15, 2026, 710 call options that are due to expire in 30 days.
I don’t want to sell calls that are too far out of the money because I want to bring in a decent amount of premium to cover most, if not all, of the protective put I’m going to buy.
The SPY May 15, 2026, 710 call fits the bill. We can sell the 710 call option for roughly $6.45, or $645 per call. We can now use the $645 from the call sold to finance the put contract needed to achieve our goal of protecting returns.
2. The next and final step is to find an appropriate protective put to purchase. There are many different ways to approach this step, mostly centered around which expiration cycle to use. Should we go out 30 days to expiration? 60 days? 120 days? It really is up to you to decide.
In this example, let’s focus on a near-term put within the same expiration cycle. A short-term put allows us to target a higher strike price for our insurance, which is particularly useful when the market is moving on headlines.
So, we’ll stick with the May 15, 2026, expiration cycle. We can buy the 680 puts for roughly $6.19, or $619 per put contract. This begins to cover any losses below 680.
*If you wanted to lower the cost of your puts, you could simply buy a put at a lower strike. You would give up some downside protection by doing so, but the cost of the protective put would be less. By that same token, if you’d like longer-running insurance, you can move your expiration date out further, but you’ll either need to pay some premium for it or accept a lower strike price.
This means that the entire cost of the puts will be covered by selling the May 710 calls.
The rationale behind this short-term collar is that I’m expecting overhead resistance (which capped the market above these levels for the last six months) to limit the potential for immediate gains while buying insurance to protect against a rapid news-driven decline should conflict flare up in the Middle East (or should this quarter’s earnings season land flat).
Total Credit: May 710 calls ($645) – May 680 puts ($619) = $26 credit
So, as it stands, our upside return is now limited to 710 over the next 30 days. If SPY pushes above 710 per share, at May expiration, our stock would be called away. Basically, you would lock in any capital gains up to the price of 710.
But the key reason to use the strategy is not about making additional returns, it’s about protecting profits.
And through using a collar option strategy, in this instance, you are protected if SPY falls below 680 (where we purchased our put option). Essentially, in exchange for capping your upside (plus a small net credit of $26 per 100 shares), you can insure your position against a sharp pullback.
And should SPY decline slightly or trade within our 30-point range, our collar will expire, and we’ll walk away with our shares (and the $26).
Options investing using collars limits your risk at an incredibly low (or no) cost and allows you to participate in further, albeit limited, upside profit potential. I’m certain you won’t regret adding this easy, yet effective options strategy to your investment tool belt.
[author_ad]
*This post has been updated to reflect market conditions.
