Booyah Breakdown: Putting On a Collar

Editor's note: Welcome to "Booyah Breakdown," an explanation of terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.

We've been dissecting options for a few weeks now. First we translated the lingo of option traders and got you in the know. Then we introduced a few basic strategies, such as a covered call and protective put, that could help you buy insurance on your stock's gains.

Well, for the grand finale, we'll discuss collars. A collar combines everything we've tackled thus far. To create a collar, you sell a call and buy a put on your underlying stock. Doing so allows you to protect your downside risk and still participate in some -- but not all -- of the stock's upside.

And with earnings season upon us, now is the perfect time to chat up collars. If you have a position that you think might slip because of a disappointing earnings announcement, "collaring" your gains might just be the answer.

Fix Your Collar

To create a collar, you'll need to purchase an out-of-the-money put while simultaneously writing (selling) an out-of-the-money call option.

Wait! Why do both? Why not just buy a protective put (like we discussed a few weeks ago) to limit your downside and leave your upside alone? Because it costs money to buy a put, so to finance the put purchase, you can sell a call, says Tom Boggs, an associate director of equity products at the Chicago Mercantile Exchange. Then the money you take in from the call will offset the cash you spend on the put.

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