A collar is a strategy that combines elements of both a protective put and a covered call.

It's typically used by investors who want downside protection while also reducing the cost of hedging by giving up some upside potential.

Let's say an investor is long the stock at 50 and is concerned about downside risk, but doesn't want to pay the full premium for a protective put.

To address this, they initially buy a three month put option with a strike price at 46, paying a premium of 1.15 to establish downside protection.

At the same time, they sell a three month call option with a strike price of 54, receiving a premium of 1.30.

The premium from the short call partially or in some cases fully offsets the cost of the put reducing or even eliminating the net premium payment.

Now, let's consider the payoff profiles.

A long stock position alone has unlimited upside, but full downside exposure.

The long per option limits losses if the stock drops below 46, acting as a form of insurance.

Meanwhile, the short call option generates income, but introduces an obligation to sell the stock at 54 if the price rises above that level.

By combining these positions, the collar strategy creates a defined price range in which the investors profit and loss, or p and l remains largely unchanged.

If the stock falls below 46, the puts provides protection, ensuring the investor does not lose more than $4 per share, excluding premiums.

If the stock price rises above 54, the investor must sell at that price capping further upside between 46 and 54.

The investor continues to participate in price movements as if they simply own the stock.

The key advantage of a collar is that it provides downside protection with little or no upfront cost.

The premium received from the short call helps offset the cost of the puts.

This makes it more cost effective than a standalone protective puts.

It also ensures the investor doesn't get stopped out at the bottom, allowing them to stay in the trade without worrying about short term market fluctuations.

However, there Are important considerations.

First, the strategy does not provide immediate downside protection.

As the puts strike price is below the current stock price, the investor remains exposed to losses down to 46.

Second, if the stock price rallies beyond 54, the investor must sell at that price missing out on further gains.

While this trade-off reduces the cost of protection, it also limits upside potential overall, a collar is a useful strategy for investors, particularly who want to hedge downside risk while minimizing hedging costs.

However, strike price selection is critical.

Choosing the right call and put strikes determines the balance between protection, cost, and upside Participation.