What is a Protective Collar?

A protective collar is a popular stock option trading strategy that is used to protect against significant losses, yet also limiting large upside gains. This strategy consists of two tactics using traditional options – protective puts and covered calls – to limit risk and capture potential upside potential.

A protective put is a strategy where the investor purchases a put option on a stock. The protective put strategy puts a floor on the value of the underlying stock, should the stock price drop. In other words, if the stock price drops to an unfavorable level, the put option will limit the losses of the investor, as the investor can exercise the put option and sell the stock at the put option's predetermined strike price.

The second part of a protective collar strategy is to write a covered call on the same stock. Essentially, selling a call option on the stock generates extra income from the premium, however it limits the upside potential of the stock. This is because the investor has already agreed to sell the stock for a predetermined price on the call option, should the stock price rise to that amount.

In order for a protective collar strategy to be effective, investors must be comfortable taking a lower gain fo the stock so that they can limit the potential loss on a stock. This means that the investor must have a pre-established strategy that matches the stock's movements and then implement the protective collar.

If the investor's expectations are met, and the underlying stock price is equal to the strike price of the written call option at expiry, then the investor will receive the maximum gain for the stock price. The small gain from the coverage option will offset the cost of the protective put, ensuring a minor profit from the strategy.

Overall, the protective collar strategy is an attractive option for investors who are looking to limit potential losses, while still generating some income from the call option. This, however, requires the investor to pre-agree to a predetermined price. If this is done effectively, the investor can protect themselves from significant losses without missing out on the potential upside of the stock.