Collar Options

A collar option is a particular investment strategy the hedges exposure to fluctuating interest rates. Derivatives are usually used to hedge the exposure, which therefore ‘collars’ the risk for the investor when it comes to the fluctuations. Collar options help limit the amount of interest paid, and increases the chance of more profits if the interest drops. Bond issues are an investment type that may be used with a collar option because when interest rates go up, bond prices go down. Using this strategy helps minimize the possibility of and the amount of financial loss to the investor.

Collars are also utilized to make an interest rate floor. This term refers to the interest rate at which a sale will take place. This ‘floor’ allows investors to anticipate the amount of return in best case scenarios and worst case scenarios. This can also work to minimize risk when it comes to investment interest rates. An example might be when a collar establishes a maximum interest rate of ten percent with a floor of eight percent. If the interest rate goes higher than the established ceiling, you would get a payment from the purchaser of the ceiling which offset any losses that would have happened because of the drop in price. This works the other way also, if the rate drops below the floor, the holder of the investment must pay the purchaser of the floor.

Many times the collar option looks at the ability to prevent loss to the investor. Although the collar option strategy can also limit the profit, this is not usually an issue investment professionals are worried about. This is because investment professionals look at the highest amount of return possible with a collar as profitable regardless of whether the rate goes above the ceiling or below the floor.

To establish a collar option, you can hold shares of a stock, buy a put for protection and write a covered call. The options are called a combination. The put and call usually have the same month of expiration, while the buy and sell are the opening trading transactions for the identical amount of contracts. This is a good tactic to utilize if you want to guard against a dramatic fall in prices of a security and are writing covered calls with the goal of earning premiums. One of the best things about the collar option is that from the beginning you are aware of possible gains and losses. Even if your profits are not as much as they could be in a favorable bull market, you have security if things go unfavorably.

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