Question

To protect an existing stock position, some traders like to use a position known as a collar. When traders have a long position in the stock, they create the collar by combining covered calls and protective puts. Therefore the upside potential is limited beyond the strike price of the short call while the downside is protected by the long put. Suppose you purchased 100 shares of stock ABC at $13 in May and would like a way to protect your downside with little or no cost. Currently the July Call option with strike price of $15 is priced at $0.80 per share and July Put with strike price of $10 is priced at $0.60.

1) To create a Collar using the call and put, what positions you need to hold? In particular, show what the covered call and the protective put positions are?

2) If on the expiration day, the stock price turns out to be $8, show what is the net profit or loss? (please show the steps that lead to your answer)

Answer 1

K: strike price

1) To create a collar

Short 100 call option (K=15)...........covered call

Long 100 put option (K=10)...........protective put

2) Total premium to be paid = (0.8-0.6)*100 = $20

If stock price ends at $8

Pay-off short call = -max(S-K,0)*100 = -max(8-15,0)*100 = 0*100 = 0

Pay-off long put = max(K-S,0)*100 = max(10-8,0)*100 = 2*100 = 200

Pay-off from collar position = 0+200-20 = $180

Pay-off from long stock position = 100*(8-13) = -$500

Net pay-off = $180-$500 = -$220 (loss)