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The Collar is a beautiful strategy if you own a stock and have a slightly bullish view. However you also fear that the stock may fall in value. Collar strategy will help you to restrict the losses without paying too much for protection. Sometimes you can also make money if stock does not move much. Compare this to some one who owns the same stock and did not deploy the collar strategy.
It is a limited profit and loss strategy.
If you are bullish in nature but also fear a fall in a stock you hold – want to participate in the rally if it comes but protect losses if the stock falls, then “The Collar” is the best strategy to adopt.
Lets look at the graph and then discuss the strategy:
Lets discuss the collar strategy.
The collar strategy will help you to make money if your view was right, and will help you to severely control your losses if your view was wrong. You need not put a stop loss and take your time to get out of the strategy with a limited loss and limited profit.
The Collar strategy involves buying a future (or in cash the equivalent value of future if you want to do it in any stock), then to manage risk, sell a OTM (not very far) call and buy a ATM put.
As you can see if your view was right and Nifty or the stock rises, the long Future will make money, but the sold CALL and the bought PUT will lose money.
You must be thinking if both CALL and PUT will be loosing money then how will the strategy make money? You see the Future moves 1 point with every 1 point rise in Nifty. However bought PUT has a limited loss. And sold CALL is OTM – so yes it will lose money but not as fast as the Future making money. Overall the strategy will be in profit.
Assuming you bought Nifty future and it starts moving down.
If the view goes wrong and Nifty starts going down – the long future will lose money but the bought PUT and sold call will make money. However since the PUT will not rise 1 point for every 1 point fall in Nifty and the sold call has a limited profit – the strategy still losses money.
But the losses will be limited as the PUT will limit the loss to a large extend. Your loss is limited to the sell price of the OTM Call minus the buy price of the ATM Put plus the profits generated by the bought Put.
Lets take an example. Lets suppose Nifty is at 6000 and you feel Nifty can go up to 6300. Recently it went up to 6300 so your view. You buy a Nifty future, buy ATM Put 6000 valued at 105.00 and sell slight OTM Call of 6300 valued at 50.00. Note that you sell 6300 Call because you think Nifty will not go beyond 6300 – so why should you speculate for that and take profits for the call as well if your view is correct and Nifty does not move beyond 6300 during expiry.
1. If the view was right:
Nifty expires at 6300.
The profit from Futures: 300 * 50 = 15000
The profit from sold Call: 50 * 50 = 2500
Total profit: 15000 + 2500 = 17500
The losses from bought PUT at 105: It expires worthless. 105 * 50 = -5250
17500 – 5250 = Rs. 12250.00
The profits are caped at 12250. Even if Nifty moves beyond 6300 – the strategy will not be able to profit more because the sold call will start to lose money.
2. If the view was wrong:
Nifty expires at 5700.
The losses from Futures: 300 * 50 = -15000
The profit from sold Call: 50 * 50 = 2500
The profit from bought Put: 300 – 105 = 195 * 50 = 9750
Total losses: 9750 + 2500 – 15000 = Rs. -2750.00
The losses are capped at 2750.00 because the bought Put will keep making money if Nifty keeps falling further.
Now lets take the risk-reward ratio.
You are risking 2750 to make 12250. This comes to risking 1 rupee to make 4.45 rupees. Isn’t this an amazing strategy?
Who should play this strategy?
This strategy is great for beginners as the risk is very limited but the rewards are high. This is one the best risk-reward strategies on playing Nifty futures and options.
The only problem with this strategy is that if Nifty does not move in the predicted direction – you will end up wasting time and money as well. For example if Nifty expires exactly at 6000. You will not be able to make any money in the futures. But you will lose money in the options. And the total loss will be: 5250 – 2500 = 2750.00.
But if 2 times out of 4 you were right – this strategy will make money over a long period of time.
The Collar strategy is therefore best for risk averse traders. Also note that this strategy also works if you are bearish in view. In that case a future needs to be sold, ATM Call needs to be bought and OTM Put needs to be sold. Of course if you are bearish, you cannot play this strategy with cash. You only can play with F&O.
If you take my course I have 2 very conservative but very rewarding option strategies. Interestingly if your view was right you will make money but you can also make money if your view was wrong. For more information about the course contact me.
Unfortunately not many traders in India trade Collar. But frankly if you have a company’s stock in cash equivalent to its Future lot size – you can trade collars almost every month to make decent returns from your portfolio. It is a great hedge if the stock falls. And still make money if it rallies. However if a big rally comes, you may not be able to reap in the full rewards because of the sold Call option. Still its a great conservative strategy.
Have you ever tried the Collar Strategy? Please let us know your experience.
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Dilip Shaw, Founder
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