Collars are protective strategies involving options that are used after a long position in a security has already achieved a significant increase. Investors use the collar strategy through the purchase of out-of-the-money put options and the selling of out-of-the-money call options. This techniques is also known as hedge-wrapping.
The out-of-the-money put option is the source of protection from a substantial downturn in the underlying security that locks in a significant proportion of the profits that have already been nominally gained yet not realized.
The cost of this profit protection through the purchase of the put option is reduced by the premium collected through the sale of the corresponding out-of-the-money call option.
The aim of this strategy is to wait for the underlying security to increase until it reaches the strike price for the call option that was sold. Therefore, while a collar will safeguard against a significant downturn in the price of a security, it will also create a relatively equivalent cap on any further gains in the value of the underlying security.
A collar can be used as a more aggressive trading strategy when there is a significant divergence between the price of puts and calls on an underlying security.
If the cost of the downside protection from purchasing the put option is much lower relative to the limits on a rise in the price of the underlying security that is set buy selling the corresponding call option, then an investor can achieve a low-cost protected bet on a rise in the price of the underlying security.