When is a Forward Collar Useful?
The forward collar strategy is useful when you expect a particular asset to remain range bound and or you want to cover against downside losses.
You can use it anywhere provided there is a liquid options market for the underlying. It’s important to check that the options market is liquid enough because this is essential for you to get in and out of the position efficiently without heavy costs.
The forward collar can be useful for:
- Covering indices
- Carry trading positions
- Fixed income positions
The structure of a forward collar is highly flexible. The “collar” can easily adjust to gain a different outcome. The structure you choose hinges on how you expect the underlying to move over a given time period.
The collar strategy is useful for hedging against losses, but it can be highly profitable too. The best case scenarios are where the underlying is trading within a range. It also works as a bet on volatility because this will determine the price paid and received for the options.
To create a collar yourself, your trading account will need the authorization to buy and sell options contracts in the underlying to be protected. Otherwise there are markets in synthetic collars, but these usually only exist on the major indices.
Analysis of a Forward Collar
A forward collar lets you know the highest profit and the biggest loss you’ll achieve. These will depend on exactly how you structure the trade.
It consists of the following parts:
The position to be protected (stock, bond, currency or other asset)
A long put option
A short call
Example – carry trade covering
Let’s say I have a long carry trade position in AUD/USD that I want to create a collar on.
Suppose AUD/USD is currently priced at 0.75 and the volatility is above its average. These aspects will determine how cheap or expensive the options will be. We want to sell our options high and buy them low.
We can now create a structure that will collar for 30 days going forward, both losses but also profits.
Position to cover long 1 x AUD/USD
Buy 1 x AUD/USD put option @ strike 0.73
Sell 1 x AUD/USD call option @ strike 0.75
The put option will cost $856.08. The short sale of the call option produces $1742.78. The collar will be in place for 30 days, owing to the expiry date of the options.
The net from the options purchase/sale is $1742.78-$856.08 = $886.70
When the collar is active, the entire position has limited upside but also is protected against downside loss. The payoff diagram is Figure 1, at the top left.
As long as AUD/USD stays at 0.75 or higher, the collar achieves its maximum profit of $886.70. If it moves above 0.75 we’ll have to pay out on the call option but that will be offset exactly by the rise in the underlying.
Figure 2 shows the payout for a scenario in which the underlying strongly rallies. The red line is the PL in the underlying alone, while the gray line is the PL of the collar, which is what we receive.
If AUD/USD drops below 0.75 at the end of the 30 days the call option expires worthless. But we keep the option premium of $1742.78. The downside on the underlying position is protected by the put option that will pay out if AUD/USD falls below 0.73.
The end result is that downside loss is limited to $1114. That’s thanks to the put and the proceeds from the sale of the call option. Figure 3 shows the payoff graph for the case when the underlying turns bearish.
Had we just held the underlying, the loss would have been nearly $5000. With the collar in place, the loss is limited at $1114.
Choosing a Collar Structure
This type of collar is good for situations where you expect the underlying to remain range bound.
But there’s no limit to how creative you can be by selecting different strike prices.
If you expect more upside movement, the call strike can be lifted higher. When the call strike is set at 0.79 and the put strike at 0.73 this gives a maximum pay off of $3591.92 against a possible loss of $2408.08.
By moving the put strike lower, you get less downside protection. But the trade-off is that the puts become cheaper, the further “out of the money” they are.
Options become more expensive when volatility increases. That makes forward collars attractive when volatility is high and especially good if it drops while the position is open. This means, you’ll make more in the sale of the call option. The put, which has to be bought, will also be more expensive, but is usually offset by the higher value of the call which is closer to the money.
When a collar is already in profit, it can be closed out early to maximize the gains.
The position to be protected doesn’t have to be long. It could just as easily be a short position. In foreign currencies for example, if the position you want to collar is short, for example a position on a carry trade pair, the collar works the same but in reverse.
The downside is protected by purchasing an out of the money call option. This is “funded” by the sale of a put option, that’s usually chosen with a strike closer to the money.
The reverse collar protects the short position against adverse upside movements. The price for that protection is giving up some of the profit, should the underlying move sharply lower.
Using Collars for Speculation
A regular collar always has a known maximum loss and maximum profit. But what happens if you leave out the position in the middle – that of the underlying?
A fall in the underlying below the put strike would mean that the put option pays out, while the short call would expire out of the money. The strategy would win if the underlying stayed the same or went into a bearish free fall. It loses if the underlying rallies.
The advantage of this kind of strategy over simply holding the underlying outright is in the collection of the option premiums.