Collar (finance) - Why Do This?

Why Do This?

In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?

If it makes more sense to hold onto the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free.The price received for selling the call is used to buy the put—one pays for the other.

Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.