Two options used in combination as a hedge for an underlying exposure to a market price. Collar hedges are more complex structures, compared with a simpler cap option or floor option.
An advantage of collars for hedging is that they reduce the net premium paid for the hedge. They do this by adding a short option position to the long position in the simple cap or floor.
In other words the hedger sells an option (in addition to buying the simple cap or floor option).
The premium received by the hedger reduces their net premium payable. The net premium payable is often zero. (This arrangement is called a zero cost collar.)
It is also possible - though less common - to construct a negative cost collar, the net premium being receivable by the hedger.
The case where the hedger pays a net premium for the collar is known as a positive cost collar.
The result of dealing in the combination of two options as a hedge is to ‘collar’ the all-in hedged expense or income achieved within a range which is acceptable to the hedger.
Collars are also known as cylinders, corridors or range forwards.
The net hedged profile achieved by the use of the two options, in combination with the underlying exposure.