Collar Agreements: A Guide to Managing Financial Risks

What Is a Collar Agreement?

A collar agreement is a financial strategy used to manage risk and lock in an acceptable range of outcomes for investments such as stocks, interests, or mergers. This strategy sets a ceiling and a floor on variables like interest rates and market values, limiting potential losses while capping potential gains.

Understanding the Mechanics of Collar Agreements

Option collars can be used for a variety of securities and risks. For equity securities, a collar agreement establishes a range of prices within which a stock will be valued or a range of share quantities that will be offered to assure the buyer and seller of getting the deals they expect. The primary types of collars are fixed-value collars and fixed share collars.

Interest rate collars hedge the risk of changes in interest rates through selling a covered call and buying a protective put simultaneously. These options establish a cap and a floor for protection.

A collar may also include an arrangement in a merger and acquisition deal that protects the buyer from significant fluctuations in the stock's price, between the time the merger begins and the time the merger is complete. Collar agreements are utilized when mergers are financed with stock rather than cash, which can be subject to significant changes in the stock's price and affect the value of the deal to the buyer and seller.

Perhaps the flashiest collar of all is used with options strategies. Here, a collar includes a long position in an underlying stock with the simultaneous purchase of protective puts and the sale of call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal to the number of contracts.

Technically, this collar strategy is equivalent to an out-of-the-money covered call strategy with the purchase of an additional protective put. This strategy is typically used when an options trader wishes to lock in significant profits, generate premium income from writing covered calls, and wishes to limit the downside from an unexpectedly sharp drop in the price of the underlying security.

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