It is the opposite of a collar, and refers to simultaneously buying a floor (interest rate floor, equity floor, etc) and selling a cap (interest rate cap, equity cap, etc). A reverse collar is simply a collar but viewed from the viewpoint of the cap seller. In general, a collar particularly suits situations where an investor has a broadly neutral to negative market outlook. In contrast, a reverse collar provides the possibility of buying higher struck puts and selling lower struck calls in an attempt to enhance an investor’s returns in a bear market. However, this comes at the risk of reducing the investor’s ability to participate in an upside market move.
| Reverse collar | Collar | ||
| Long cap + short floor | Short cap + long floor | ||
| Credit | Debit | Credit | Debit |
| Cap proceeds > floor cost | Cap proceeds < floor cost | Floor proceeds < cap cost | Floor proceeds < cap cost |
Therefore, a reverse collar is similar to a standard collar as both are used to hedge a profitable open position. However, and unlike a standard collar, a reverse collar is typically created to overlay a short position, thus reducing the existing exposure resulting from a short equity position. The long call option helps protect against a rise in price of the short exposure, while the short put is intended either to fully or partially offset the premium paid for the call. Effectively, the short put places a cap on the potential appreciation in the short equity if its price falls below the strike price of the put.
