When to use
When we want to generate additional income from an already existing long stock position (covered call), but simultaneously protect ourselves from a downward movement in stock price (protective put). In that case the short call premium should be greater than the long put premium (credit spread), otherwise we cannot generate income.
If our main goal is to protect the stock position from downward movement instead of generating additional income, then the short call premium might be lower than the long put premium (debit spread). In that case we partially finance the cost of the protective put by writing the call. The expiration dates should be the same for both options.
We accomplish maximum profit at expiration when the price of the underline is equal or above the short call strike and maximum loss if the underline price is equal or below the long put strike.
Loss/Profit at expiration
Maximum loss: (Price we bought the stock – long put strike price) + net premium paid (minus if earned) + commissions.
Maximum profit: (Short call strike price – price we bought the stock) – net premium paid (plus if earned) – commissions.
Below we can see the profit diagram for the collar strategy. 100 shares have been bought at $26, the long put has strike $24 and premium $1 and the short call has strike $28 and premium $1.50. Notice the similarity to the profit diagrams of the call bull spread and put bull spread.
Collar strategy example
In EMC daily chart (below) we have open a long stock position when price approached a support level for the first time (point A). Although we believe in a modest price rising for the next month, we fear that due to short term market pessimism our expectation might be wrong. In that case we can buy OTM puts with strike price $21 to protect our stock position from an imminent decline below this level and simultaneously sell calls with strike $26 because we believe that a strong resistance zone at this level (between lines 2 and 3) will not let the price rise for the next month. The premium we will receive from the short option position is less than the premium we will pay for the long position, so we are partially financing the long puts through the writing of calls. In this case the downside protection of the stock position is our major consideration.