Collars on a single stock

In short

A friend of mine once held most of his savings in the stock of the company he worked for, and he lost sleep over it. If you are in that spot, a collar is one tool that can calm the nights. It pairs two options on the same shares, so you set a floor under your loss and a ceiling over your gain. You buy a put, which lets you sell your shares at a set price, and you sell a call, which lets someone else buy them from you at a higher set price. The call money often pays for most or all of the put. Before you place a trade, look at your tax lots and your broker's options approval level. Then talk with a tax professional, because the way a collar is built can change how the IRS treats your shares.

The whole of it

What it is

I once watched a neighbor put a sturdy fence around a pasture, and what struck me was how little the fence cost compared with the cattle it kept in. A collar works on that same notion. You own shares of one company, and you would like to keep them but limit how far they can fall. So you build a fence on both sides.

Here is the plain picture. You hold 1,000 shares. You buy a put option, which is a contract giving you the right, not the duty, to sell those shares at a chosen price called the strike. That is your floor. You also sell a call option, a contract giving the buyer the right to purchase your shares at a higher strike. That is your ceiling. The cash you collect from the call helps pay for the put. When the two cancel out, people call it a zero cost collar.

You give up something for this peace of mind. If the stock soars past your ceiling, you do not share in the extra gain. That is the price of the fence.

How it works

If you are holding a pile of company stock, you have probably felt both hope and worry. A collar speaks to both. Let me walk through the moving parts slowly, because each one matters.

You pick an expiration date. Options last for a set time, from a few weeks to a couple of years. When that date arrives, the contracts end, and you decide whether to build a new fence. You pick the put strike and the call strike. A put strike further below today's price costs less but protects less. A call strike closer to today's price pays you more but caps your gain sooner.

Now picture three endings. If the stock falls below your put strike, the put gains value, and your loss stops at the floor. If the stock lands between the two strikes, both options expire with no value, and you keep your shares. If the stock climbs above the call strike, your shares may be called away, meaning you sell them at the ceiling price. That last ending deserves real thought. A sale can trigger a tax bill.

Most brokers ask you to apply for options trading and give you a level of approval. Selling a call against shares you own is called a covered call, and brokers generally treat it as lower risk than other options trades. Check with yours on what it allows.

One more thing. Options on U.S. listed stocks are cleared through the Options Clearing Corporation, and the Options Industry Council publishes plain education on how these contracts work. Those are good places to read before you act.

The numbers, and where to find yours

You have probably noticed that the tax side of this is where people trip. So let me point you to the numbers you will want in hand, and where each one lives.

First, your cost basis and holding period for each tax lot. A tax lot is a batch of shares bought on one date. Your broker's account page shows these, and your Form 1099 B shows them after a sale. Second, your long term capital gains rate, which depends on your income. The brackets are set by law and change by year, so the figure is the current figure, which the official source publishes each year. Third, the extra tax on investment income for higher earners, known as the net investment income tax. Its threshold is the current figure, which the official source publishes each year and its rate is the current figure, which the official source publishes each year. Fourth, the date your shares reach long term status, which the law sets as held for more than the current figure, which the official source publishes each year.

Why does the holding period matter for a collar? The tax code has rules called straddle rules, found in Section 1092 of the Internal Revenue Code. A collar can count as a straddle, which may pause or reset your holding period. There is also a constructive sale rule in Section 1259, which can treat a very tight collar as if you had sold the shares. IRS Publication 550, Investment Income and Expenses, is the place to read how options and straddles are handled. The IRS has not published a simple rule for how wide a collar must be to avoid constructive sale treatment, so this is a question for your tax professional, not a guess.

Your own option prices come from your broker's option chain, which lists each strike, expiration, and price. Prices move all day, so look at them when you are ready to act, not before.

A worked example

A woman I will call Dana works at a software company and earns 240,000 dollars a year. She holds 1,000 shares of her employer's stock. Today the stock trades at 100 dollars a share, so her position is worth 100,000 dollars. She bought the shares years ago, and her cost basis is 40 dollars a share. Dana worries about a drop, but she does not want to sell and pay tax.

She looks at the option chain for an expiration one year away. She picks a put with a strike of 90 dollars. The put costs 6 dollars a share. She picks a call with a strike of 120 dollars. The call pays her 6 dollars a share. Check the math. The put costs 6 dollars times 1,000 shares, which is 6,000 dollars. The call brings in 6 dollars times 1,000 shares, which is 6,000 dollars. The net cost is 6,000 minus 6,000, which is zero. That is her zero cost collar. These prices are Dana's own figures for the example, not real quotes.

Now see where she lands at expiration. If the stock drops to 60 dollars, her shares are worth 60,000 dollars. But her put lets her sell at 90 dollars, so she protects 90,000 dollars. Her loss is 100,000 minus 90,000, which is 10,000 dollars, not 40,000. Good. If the stock sits at 105 dollars, both options expire worthless. She keeps shares worth 105,000 dollars. If the stock jumps to 150 dollars, the call caps her at 120 dollars. Her gain is 120,000 minus 100,000, which is 20,000 dollars, not 50,000. She gave up 30,000 dollars of upside for the floor.

If her shares are called away at 120 dollars, she sells 1,000 shares for 120,000 dollars. Her basis was 40 dollars a share, so 40,000 dollars total. Her gain is 120,000 minus 40,000, which is 80,000 dollars. How that gain is taxed depends on her holding period and on how the straddle rules applied along the way. She sits down with a tax professional before she starts, not after.

Where it goes wrong

I have a soft spot for folks who try to do right by their savings, so I will be gentle but plain about where collars trip people up.

The tax trap is the biggest. A collar set too tightly can be treated as a constructive sale, and the gain may become taxable right away, even though you still hold the shares. A collar can also reset your holding period under the straddle rules. Either one can undo the reason you built the fence in the first place.

Next, the capped upside is real. If your company has a great year, you will watch the gain sail past your ceiling. That can sting. Know it going in.

Early assignment is a smaller risk. The person who bought your call can sometimes use it before expiration, especially near a dividend date. Your shares may leave sooner than you planned.

Then there is cost. Even a zero cost collar has trading fees and a gap between buy and sell prices on the options. Those small amounts add up. Rolling the collar into a new one each year repeats them.

Last, an employee may face company rules. Many firms bar staff from trading options on their own stock, and insiders may have blackout windows. Read your company's insider trading policy first. Plain truth, this one can cost you your job.

Questions to answer before you leave this page

What share of your savings sits in this one stock, and how would you feel if it fell by a third? Do you know the cost basis and holding period of each tax lot you own? Has your tax professional looked at the straddle rules and the constructive sale rule for the exact strikes you have in mind? Does your employer allow options on its stock, and are you inside a blackout window? Are you comfortable giving up the gains above your ceiling in return for the floor? Would a sale of some shares, with the tax that follows, fit your goals better than a collar? And have you checked the live prices on your broker's option chain, with fees included, before you decide?