The protective collar strategy provides downside protection through the use of index put options but finances the purchase of the puts through the sale of short index call options, in effect trading away some upside potential. By simultaneously purchasing put options and selling call options with differing strike prices and the same expiration (the strike of the put is lower than that of the call), a collar often can be established for little or no out-of-pocket cost. The index puts place a "safety net" under a diversified portfolio by protecting value in a declining market, "insurance" against the risk of a decline. The index call sale generates income to offset the purchase of the protective puts. It is important to note that, depending on the call strike price and the level of the index at expiration, assignment of the short call position may have the effect of limiting portfolio gains.
As a simple hypothetical, assume Fund X maintains a portfolio roughly matching the composition of the Standard & Poors 500 Stock Index (SPX) and that the SPX is at 945.
Fund Xs manager wants to establish a collar to protect $100 million of the funds value from a market decline of greater than 7 percent for the next 30 days. The fund manager might determine the number of times to effect the collar by dividing the amount to be hedged ($100,000,000) by the current aggregate SPX value (945 x $100 or 94,500), i.e. 100,000,000/94,500 = 1058.2. Since fractional contracts cannot be purchased, assume the fund implements the SPX collar by selling 1,058 call options and purchasing 1,058 put options.
To establish the collar, the fund manager might select an SPX put contract with a strike price approximately 7 percent below the current aggregate SPX value. With the SPX at 945, an SPX put contract with a strike price of 880 and 30 days until expiration might be quoted at 4-5/8.
Next, the fund manager may choose to select a call contract currently quoted at a price sufficient to pay for the put purchase. With the SPX at 945, an SPX call contract with a strike price of 995 and 30 days until expiration might be quoted at 5-1/2.
This collar can be established for a net credit of $92,575: $581,900 received from sale of calls (1,058 call contracts sold x $5.50 premium x $100) less $489,325 paid for purchase of puts (1,058 put contracts purchased x $4.625 premium x $100).