Editor’s Note: If you’ve ever stared lovingly at a stock in your portfolio while quietly panicking that it might nosedive tomorrow, it might be time to consider a collar option.

Think of it as the financial equivalent of wearing a helmet while riding a unicycle on a tightrope: it won’t stop the wobble, but it’ll keep you from cracking your skull if things go sideways.

A collar option is a clever little strategy that cushions your portfolio from wild market mood swings, all while capping your risk. The trade-off? It also puts a ceiling on your potential gains, sorta like being told you can only eat half the cake because it’s safer for your cholesterol.

But hey, in return you get something priceless: peace of mind. No matter which way your stock decides to swing—up, down, or interpretive dance—your portfolio will keep its composure like a seasoned poker player.

Coming up, I’ll break down how a collar works and whether it deserves a spot in your risk-management toolkit.

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What Is a Collar Option?

A collar option combines two options strategies: a protective put and writing a covered call against shares of stock that you own. As a result, it limits your loss and could also limit your return.

The protective put is the part that limits your loss. If your stock falls below the strike price of the put option, it will increase in value dollar-for-dollar as the price of the stock drops below the strike price.

However, if your stock rises in value and crosses the strike price of the covered call, then whoever bought that call from you is going to exercise his or her right to purchase the shares. You’ll sell the stock at the strike price.

On the other hand, there are other scenarios as well.

If the stock you own doesn’t pass the strike price before the option expires, then you keep the money you earned from the covered call and you still own the stock. Of course, you’ll be out the cash that you spent on the put option.

If, for whatever reason, the bottom falls out from under that stock, you’re protected by the put option.

When Would You Use a Collar Option?

Use a collar option when you’re bullish on a stock you own but a little nervous.

A collar option is especially valuable if you’ve seen a nice run-up in the stock but you’d like to hedge before selling.

Also, if you’re at or near retirement, a collar option is an excellent way to limit your risk without resorting to buying bonds. Find a stock in your portfolio that’s had a nice run-up and put a collar on it.

However, a collar option is often not a great strategy if you’re young. That’s because you’ve got plenty of time to ride out swings in the market.

In your youth, many analysts believe it’s a good idea to be a little more daring with your investments.

How Does a Collar Option Work?

There are three components to a collar option:

• Owning (or buying) a stock (long position);
• Buying a put at an out-of-the-money strike price; and
• Writing a covered call at an out-of-the-money strike price.

Let’s cover each of those in detail.

For starters, you need to own a stock before you can practice a collar option. That’s because part of the strategy involves writing covered calls and you can’t do that without owning the underlying stock.

Also, you’ll need to own at least 100 shares of the stock. Otherwise, you still won’t be able to write a covered call option because options are traded in blocks of 100 shares.

Once you own a stock, the second part of the strategy involves buying a put option that’s out of the money.

In the case of a put option, “out of the money” means its strike price is below the current stock price.

After purchasing the put, you write a covered call that’s also out of the money. In the case of a covered call, though, “out of the money” means the strike price is higher than the current stock price.

Also, keep in mind, that you’ll earn money when you write the covered call. That’s because you’re selling a call option.

It’s often the case that investors use the income from selling the call option to buy the put option.

Hypothetical Use of a Collar Option

Let’s say you own 100 shares of ABC Corporation. They’re currently trading at $48 per share.

Several years ago, you bought the stocks at $25 per share, so now you’re sitting on a $23 per share (or $2,300) unrealized gain.

You’d like to sell the stock because there’s been some volatility in the market lately. However, you think that ABC still has room to grow.

Instead of selling, you opt for a collar option.

You find an expiration date that’s a month out. You buy the protective puts for $1.05 per contract with a $47 strike price. That costs you $105 because an options contract represents 100 shares of stock ($1.05 x 100 = $105).

Then, you turn around and write a covered call at $49 per share for the same expiration date. You see that the option is currently trading at $0.98 per contract so you earn $98 ($0.98 x 100) from the sale of the option.

If ABC goes above $49 per share and stays there after the expiration date, the person who purchased the call from you will exercise the option to buy the stock at $49 per share. Your gain will be limited to $2,400 ($4,900 earned from the sale minus your initial investment of $2,500).

Still, you make a profit. You just limited the profit potential.

On the other hand, if the ABC stock price collapses, you’re covered by the protective put. It’s like the stock price could never drop below $47 per share.

In that case, you still make a profit. You’re effectively earning $4,700 ($47 x 100) from the sale of the stock and pocketing a realized gain of $2,200.

Strategies Similar to Collar Options

Here are a few strategies similar to collar options:

• Costless Collar – The same thing as a collar option except the money earned from the covered call is exactly equal to the money spent on the protective put.
• Bull Put Spread – A strategy involving selling an in-the-money put option at one strike price while buying an out-of-the-money put option at a lower strike price.
• Bull Call Spread – A strategy involving buying an at-the-money call option while also writing a call option at a higher strike price.

Collar Option Compared to Other Options Strategies

The most important concept to remember about the collar option is that it can limit your profit. There are many other options strategies that don’t do that.

The protective put, for example, will limit your downside with the put option. However, your gain is unlimited.

Read This Story: A Safety Net for Your Stocks: Meet the Protective Put

The same is true of a long call option. If you just buy calls at a low price (relative to the stock price), then your potential for gain is unlimited. The maximum amount you can lose is the price of the call option.

Advantages and Risks of the Collar Option

Advantages

• Limited risk – A collar option is basically an insurance policy. It limits your risk in a volatile market or if the stock you own is hit with some very bad news and the price drops dramatically.
• Stock ownership – You’ll own the stock at least through the duration of the contract. That means you’ll get dividends if the company pays them during that period. You can also keep the stock if it never appreciates in value past the strike price of the covered call option. In that case, you also pocket the money earned from the writing the covered call.

Risks

• Limited gain – If your stock price rises significantly during the period before the covered call expiration, you’ll miss out on a lot of those profits. That’s because the most you’ll sell that stock for is the value of the covered call strike price.
• Potential for loss – If you just buy a stock and put a collar option on it, you could still lose money. Sure, your loss is limited by the protective put, but that doesn’t mean you can’t lose anything.

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Jim Fink is the chief investment strategist of several premium trading services, including Velocity Trader, Options for Income, and Jim Fink’s Inner Circle.