Mixing Exposure  •  259
The Gist
This structure is really much simpler and has a much more straightfor -
ward investment purpose than it may seem when you look at the preceding 
diagram. When people talk about “taking profits” using a covered call, the 
collar is actually the strategy they should be using.
Imagine that you bought a stock some time ago and have a nice 
unrealized gain on it. The stock is about where you think its likely fair 
value is, but you do not want to sell it for whatever reason (e.g., it is 
paying a nice dividend or you bought it less than a year ago and do not 
want to be taxed on short-term capital gains or whatever). Although you 
do not want to sell it, you would like to protect yourself from downside 
exposure.
Y ou can do this cheaply using a collar. The collar is a covered call, 
which we have already discussed, whose income subsidizes the purchase of 
a protective put at some level that will allow you to keep some of the unre-
alized gains on your securities position. The band labeled “Orange” on the 
diagram shows an unrealized gain (or, conversely, a potential unrealized 
loss). If you buy a put that is within this orange band or above, you will be 
guaranteed of making at least some realized profit on your original stock 
or index investment. Depending on how much you receive for the covered 
call and what strike you select for the protective put, this collar may rep-
resent completely “free” downside protection or you might even be able to 
realize a net credit.
Execution
The execution of this strategy depends a great deal on personal prefer -
ence and on the individual investor’s situation. For example, an investor 
can sell a short-tenor covered call and use those proceeds to buy a longer-
tenor protective put. He or she can sell the covered call ATM and buy a 
protective put that is close to ATM; this means the maximum and mini-
mum potential return on the previous security purchase is in a fairly tight 
band. Conversely, the investor might sell an OTM covered call and buy 
a protective put that is also OTM. This would lock in a wider range of 
guaranteed profits over the life of the option.