What is a collar strategy and how does it work?

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A collar strategy is a trading strategy used by stock market investors to reduce their risk and protect themselves from major losses. It involves buying an out-of-the money put option and simultaneously selling an out-of-the money call option with the same expiration date. By doing this, it creates a “collar” around the investor’s current holdings that acts as a buffer against large price drops in the underlying asset. The cost of purchasing these options reduces or even eliminates any potential profits gained if the underlying asset rises above the strike price of either the call or put option, but provides protection should there be significant downside risk in the underlying asset.

When using this strategy, investors essentially have two choices: they can purchase both options at a net cost (which will reduce their potential returns), or they can sell both options at a net credit (which will maximize their return). In either case, if there is limited upside potential on the security being hedged then investors may choose to pursue a collar strategy as opposed to other risk management strategies such as covered calls which require them to pay premiums for additional protection.

The primary benefit of utilizing a collar strategy is that it offers excellent risk management capabilities for those looking to protect their holdings from downward movements in price while avoiding costly margin requirements that usually accompany short positions on stocks or indexes. Additionally, because investors are long one position and short another, they are able to take advantage of any volatility in between strikes over time – i.e., if one leg of their collar gains value due to increased volatility then it could offset losses from decreases in value on its counterpart leg.