How do equity collar work in simplest of language. I also noted that equit collars were in 2007/8 exam as one of the ways to manage concentrated positions with some upside potential. i cant figure out why an equity collar would preserve an upside potential.
The key is that it is “some” upside potential. If it is a zero cost collar, then the max upside is the call strike price minus the current price of the stock.
If your stock is worth $100 and you sell a call with a strike price of $105 (and buy a put to compete the collar), if your stock price rises to 105 or higher, you make the profit between the 100 and the 105, with anything over 105 being paid back to the holder of the call you sold.
So there is “some” upside potential with a collar, just as there is “some” downside potential, with the downside being limited to the difference between the current stock price and the strike price of the put.
^ good explanation. I could just add that you can also think about it like a “protective put” the cost of which is offset by selling an OTM call option. The protective put limits your downside risk but at a cost. Writing a call can make the collar “zero-cash” but at the cost of capping your upside potential, like explained by S666. A suitable strategy, if you anticipate no further price appreciation of your long holding but are concerned with a potential retreat in price.
So the difference between Equity Collar and Forward coversion with options is that:
Equity collar doesn’t create a riskless position. Let’s say you bought a stock at $100 and you long put at X=100 and short call at X=105. Basically you have some upside potential if the price moves between 100 and 105 and you have complete downside protection.
Forward conversion wth option creates a riskless position for you to borrow at a high loan to value ratio. If you bought a stock at $100, you would sell call and long put at X=$100 so this position is risk-free.
AM I RIGHT?
Thanks!
right, Both use long put and short put. Difference is the usage of different strike prices and primiums. Zero collar uses same premium, fwd conv. uses same strikes
In zero collar, to reduce cost you match premiums of long put and short call and reduce some upside potential, (but still have some upside X- price)
In FC your posisiton creates a riskless position with deferred cap gain tax and high LTV… Upside downside moves offset each other.