The Put Spread Collar

by Randy Frederick, Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Key points

• Collars combine a covered call and a protective put.
• Collars help you cost effectively protect a position that you're not ready to sell—but they limit your upside potential.
• A put spread collar is a sophisticated strategy for experienced option traders that can allow for more upside profit potential if you're willing to take a little more risk on the downside.

A collar is a risk-management strategy that combines a covered call and a protective put. An investor who establishes a collar is usually concerned with protecting a position in a cost effective way. While a collar can provide short-term protection against a downturn in the stock, it also limits upside return.

But what if you only need some downside protection—for example, if you think a potential downturn will be limited and not catastrophic in scope. Or, what if you want more upside potential, but without spending any additional money?

If either of these scenarios applies to you, consider a put spread collar.

What is a put spread collar?

As with a traditional collar, a put spread collar is usually set up so that both the long (protective) puts and the short (covered) calls are out of the money, but with the same expiration date. However, with the put spread collar, the long put position can be purchased much closer to the money than the short call position and the difference in price is offset by the sale of a farther out-of-the-money put position.

This structure allows for greater upside potential, with less downside risk when there is only a small decline in the price of the stock. However, if there is a big decline, downside losses could be significant. A put spread collar is essentially a covered call combined with a bearish put spread.

An example of a put spread collar

To illustrate this strategy, let's assume that a couple of months ago, you purchased 1,000 shares of XYZ at a price of $26 and since then the stock price has risen to $28.30. You are optimistic about the long-term prospects of XYZ, so you don't want to sell it, but in the short term you're concerned about a possible small pullback. No matter what happens though, you believe there will not be a large decline.

You only have a 2.30 unrealized gain in this stock so you would like to limit your immediate downside risk as much as possible without spending a lot of money. However, because you're bullish you'd like to leave a fair amount of room for the upside too.

The solution may be to establish a put spread collar as follows:

This position ensures that you won't lose more than 0.80 unless XYZ drops more than 3.30 points. However, you can make 6.70 points if XYZ rallies. Your only out-of-pocket expense would be the commission charges. Let's take a look at this strategy (as of expiration date) on a profit and loss graph.

Profit and Loss for a Put Spread Collar

Source: Schwab Center for Financial Research.

As you can see in the chart above, based on the starting price of 28.30, your profit, loss and breakeven thresholds at expiration are:

• Below $25 there is downside risk to zero. The maximum loss is 25.80 or -$25,800 if XYZ drops all the way to zero.
• From $25 to $27.50, the loss is limited to .80 points or -$800.
• From $27.50 to $28.30, the loss will range somewhere between -$800 and $0.
• From $28.30 to $35, the gain will range from $0 to $6,700.
• At $35 or above, the gain is capped at a maximum of $6,700.

Like a traditional collar, with a put spread collar you can specify how long you need the protection. One nice feature is that the costs should not change materially based on the length of time holding this strategy, because time value affects all the options similarly and the option premiums essentially cancel each other out.

Depending upon the price of XYZ at expiration, some of the options could expire worthless, get assigned, or be exercised, so in order to reach the profit and loss scenarios described above, let's compare the put spread collar to a similarly structured (zero cost) traditional collar.

The table below identifies exactly what takes place at each price point. For comparison purposes, let's assume all positions are purchased when XYZ is at the current market price of $28.30.

How Do They Stack Up? A Traditional Collar vs. a Put Spread Collar

Source: Schwab Center for Financial Research.

In the table, you can see that the traditional collar and the put spread collar have essentially the same initial cash outlay (not including commissions) and gains and losses at prices between $25 and $29.

However, at prices below $25, losses will not exceed $800 on the traditional collar but will continue to get worse as the stock drops on the put spread collar. Because the put spread collar is short 25 puts, they will need to be closed out in the market, and the farther the stock drops the more expensive this will be. The maximum loss on the put spread collar is -$25,800. Essentially the downside protection on the put spread collar ends if XYZ drops below $25.

At prices above $29, gains will not exceed $700 on the traditional collar but will continue to grow on the put spread collar until a price of $35. At all prices above $35, the maximum gain on the put spread collar is $6,700. This additional $6,000 of potential upside opportunity is the trade-off for the extra risk taken below 25.

The bottom line is that a put spread collar is only appropriate when you are trying to protect against a modest decline in price—not a severe decline.

What to keep in mind

A put spread collar is a unique strategy, suited for specific situations so I'd like to conclude with a summary of its benefits and risks:

Benefits

• Provides limited downside protection at very low or potentially zero cost.
• Allows for greater upside profit potential versus a traditional collar.
• If the stock stays within the range of the call option and the higher strike put, the cost is zero or very low and all options expire worthless.

Risks

• While this strategy does limit risk somewhat, if the stock declines below 25 your losses could be quite significant.
• Anytime you sell a call, you have established a maximum selling price for your stock. While this strategy does allow for greater upside potential, if the underlying stock moves substantially above the short call strike price, your profit potential will still be limited.
• If your short calls go in-the-money, you could be assigned at any time.
• All options eventually expire, and the benefit of this strategy ends at expiration.
• Because a put spread collar is a spread, you have to be approved for spread trading in order to utilize this strategy.

For additional information on this strategy or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

Important Disclosures

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.

With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Writing uncovered options involves potentially unlimited risk.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

Past performance is no indication (or "guarantee") of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.