A collar is a hedging strategy whereby a position in the underlying stock is held along with two options which will cap gains and protect against losses. Both options are held in equal amounts and have the same expiration.

For a long stock position, the collar is constructed via a covered call (which caps upside gains) and a long put to protect the downside.

For a short stock position, the collar is constructed via a covered put (which caps gains on the downside) and a long call to protect the upside.

It’s common that both of the options are OTM, although not required.

Typically, this strategy is used by a trader who wants to hedge against any adverse move in the share price, while still allowing for a limited amount of additional gains in the position. It tends to be most effective when the trader feels the stock position has effectively run its course, but the trader is willing to allow for a bit more movement in either direction.

Some traders aim to establish collars with little to no cost, and at times for a small net credit. When a debit is paid to establish the collar, it tends to bring greater potential gain and reduced loss in the position. Collars which are done for credits tend to involve greater potential loss and reduced potential gain.

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