An investor writes a call option and buys a put option with the same expiration as a means to hedge a long position in the underlying stock. This strategy combines two other hedging strategies: protective putsand covered call writing.
Usually, the investor will select a call strike above and a long put strike below the starting stock price. There is latitude, but the strike choices will affect the cost of the hedge as well as the protection it provides. These strikes are referred to as the ‘floor’ and the ‘ceiling’ of the position, and the stock is ‘collared’ between the two strikes.
The put strike establishes a minimum exit price, should the investor need to liquidate in a downturn.
The call strike sets an upper limit on stock gains. The investor should be prepared to relinquish the shares if the stock rallies above the call strike.
In return for accepting a cap on the stock’s upside potential, the investor receives a minimum price where the stock can be sold during the life of the collar.