Collar at the Inception of a Trade
The collar requires three components: the initial trade, long or short; an out-of-the-money option that is purchased to lock in profits, either a call or a put; and an out-of-the-money option (which sits ahead of your initial trade) that you sell. For instance, if you have a long collar trade on the euro, you purchase a put at support, go long the market, and sell a call at some point of resistance.
If we look at an example in a different time frame, we see a run up in the value of the euro. This time we see a peak, along with an opportunity to short the market. We purchase a call, short the market, and explore the two options to sell puts. The further out-of-the-money, the lower the premium we can collect. But we also give ourselves more breathing room by not capping off our profit potential too quickly.
Benefits and Drawbacks
Placing a collar on at the inception of a trade can make sense in some cases; there are some key benefits, as well as drawbacks, to keep in mind.
There are three key benefits to using a collar at the inception of a trade. First, you are able to calculate your potential profit right away, whether the contract is futures, spot, SSF, or CFD. This can be comforting when your intent is to adhere to a strict risk/reward ratio for your trade. If you intend to not risk more than $1 to gain $2 or $3, the potential maximum gain quickly becomes apparent.
Second, by initiating a collar trade at the beginning of a trade’s execution, you are afforded some protection if the market moves against you quickly. You are essentially putting on a synthetic trade, which can be very expensive because you are purchasing an at-the-money option as a form of protection. The collar has a sold option component that allows you to collect some premium to offset the costs of the at-the-money option. While you will not cover the entire cost of your option purchase, you will be able to cover a part of your expense.
Finally, you have two distinct ways to profit. You can profit either from the trade with your primary short or long position or from your purchased option position and collect the premium. A standard trade would require you to be long or short and use a stop loss to protect you from the market moving against you. A synthetic trade will allow you to catch a market drop if the market moves against you, but a collar trade will pay you for being wrong through the premium you collect.
With all these fantastic benefits of using a collar immediately upon inception of a trade, there is one essential drawback. You make your money from picking the right market direction, not from the options. While the options are designed to protect you from various drops or pull backs in the market, if the core trade never develops, you have to the risk of losing money on the option you purchased as the time value erodes. Depending on how quickly this occurs, you could end up losing a significant amount of your principal while you wait for a trade to evolve. This is where understanding the option greeks becomes important.
