Collar explained — protecting unrealized gains with options

okx learn
OKX Learn
2022.06.30

Collars are options strategies used to defend against large losses at the expense of big-gain potential. They are also commonly called hedge wrappers or risk-reversals and are created when a trader — who is already long a cryptocurrency — simultaneously buys a put option and writes a call option. Both of these options are out-of-the-money.

The put option portion of a collar essentially protects the trader from a price drop in the underlying coin or token. The call option, meanwhile, helps offset the cost of buying the put option. It also provides profit potential up to (but not higher than) its strike price.

In the simplest terms, a collar is when someone who is already long buys a downside put while selling an upside call in order to hedge against major losses. This protection comes at a cost — namely, the mitigation of large-gain potential.

The best-case scenario for a collar is when the coin or token’s price equals the strike price of the call option at the expiration.

How collars provide protection

The collar options strategy is most useful when an investor is currently long a cryptocurrency and is sitting on significant unrealized gains. Secondarily, collars are also useful for long-term bullish investors unsure about short-term price action. However, collars are not ideal strategies for extremely bullish investors. In essence, collars help protect unrealized gains in the event of a cryptocurrency’s price decrease.

There are actually two strategies at play in a collar:

  • Protective put
  • Covered call

A protective put (which is sometimes called a married put) is when a trader is long both a put option and the underlying coin or token. A covered call (which is sometimes called a buy/write) is when a trader is simultaneously short a call option and long the underlying coin or token.

With these two strategies involved in a collar, it is buying the put option that actually provides protection in the event of a significant price decrease in the underlying cryptocurrency. At the same time, it is the selling of a call option that would — if executed ideally — provide enough premium to offset the purchase of the put option.

How much can you profit from a collar?

A collar’s maximum profit equals the net premium of the combined put and call subtracted from the call option’s strike price. The net of the put and call premiums is also subtracted from this total.

A collar’s maximum loss, meanwhile, is the put option strike price and net premiums subtracted from the cryptocurrency’s purchase price.