Many investors view options as a purely speculative tool—a way to supercharge returns in the stock market. Certainly, options can be employed in that manner, but that’s far from the whole story. In The Energy Strategist, I’ve frequently recommended using a handful of basic options strategies as a means of reducing risk and allowing investors to sleep well at night regardless of overall market volatility.

I highlight two of my favorite options strategies—put insurance and call replacement—in a special report posted to the Web site, titled The ABCs of Options to Hedge Risk. I encourage all readers unfamiliar with defensive options strategies to read this report carefully. I also recently recommended a defensive options strategy for Wildcatters Portfolio holding Weatherford International in the Feb. 6 issue, Earnings on Tap.

But put insurance and call replacement aren’t the only two defensive options strategies around. Collars are a third strategy all investors should add to their toolbox. Although collars may seem slightly more complex, they’re really not much different from the basic put insurance strategy I’ve outlined on numerous occasions.

Let’s take the case of coal mining giant Peabody Energy (NYSE: BTU). Shares of Peabody are up more than 50 percent since I recommended the stock, and I see considerable additional upside. I wouldn’t be surprised to see Peabody touch its all-time high around $70 per share over the next few months. For those unfamiliar with my bullish case for coal, check out the Jan. 2 issue, Taking Stock of 2007.

Although there’s plenty of upside potential for Peabody, the stock has seen some wild swings in the past two months. And a 50 percent gain is worth protecting. To help insure your gains through June, you could purchase the Peabody Energy June $55 put options (BTU RL). Each contract costs roughly $510; this is how much you’d need to spend to insure each 100 shares you own.

But $510 is a lot to pay to insure a position worth just $5,700 (100 shares at $57). Here’s where the collar comes in to play. In addition to purchasing the puts, you can sell the Peabody Energy June $70 call options (BTU FN) for $230 per contract. This would make the overall cost of the collar only $280 ($510 cost for the puts minus $230 in proceeds for the calls).

Consider four possible scenarios for Peabody between now and June 20, 2008 (the June options expiration date). For ease of illustration, I’ll assume that Peabody currently trades at $57.

• Peabody stays put near current levels. In this case, your puts would expire worthless and so would the calls you sold. You would, therefore, lose the entire $510 you spent on the puts but would get to keep the $230 you sold the calls for a net loss on the collar of $280 per contract.
  
  You would, of course, still own your Peabody stock and would still be sitting on a nice profit on that position.

• Peabody falls to $45. Your puts are now worth $10 or $1,000 per contract, and the calls you sold are worthless. Therefore, your profit would be $720 for each collar contract you purchased ($1,000 for the puts minus your initial purchase price for the collar of $280).
  
  In this case, your Peabody stock would be worth $12 less per share or $1,200 for every 100 shares you own. But because of the $720 profit on the collars, your actual loss for every 100 shares would be just $480 ($1,200 minus $720). The collar protects your profitability even more than basic put insurance because you get to retain the proceeds from the calls you sold.
  
  
• Peabody rallies to $70. In this case, the puts you purchased are worthless, as are the calls you sold. Therefore, you’d lose your entire $280 collar position.
  
  That said, you would be up a further $13 per share or $1,300 per 100 shares on your position in Peabody. You’d also be better off than if you’d simply purchased the puts outright without taking in proceeds by selling calls.
  
  
• Peabody soars to $100. In this case, your puts are worthless, but the calls you sold are worth $3,000 per contract. You’re, therefore, losing money on the calls.
  
  However, that loss is balanced by a commensurate gain in the value of Peabody. The net effect: You’d give up all appreciation in Peabody stock above $70 per share (the strike price of the calls).

To make a long story short, collars offer investors the opportunity to buy put insurance at a reduced cost. They’re a useful strategy during times when options are expensive; this occurs during volatile market environments such as we’re seeing today.

But as with all strategies, you don’t get something for nothing with collars. By selling the calls, you’re giving up some of your potential upside in the stock; you won’t participate in any upside in the stock above the strike price of the calls you sell.

In addition to the Peabody collar I just outlined, another logical collar trade would be on Quicksilver Resources (NYSE: KWK), the natural gas-focused exploration and production (E&P) firm I discussed in the most recent issue of TES. The collar I suggest for Quicksilver Resources would be: Buy the September $32.50 puts (KWK UZ) for roughly $360 per contract, and sell the September $45 calls (KWK II) for $175 per contract.

This collar costs about $185 per 100 shares insured and protects you against declines in Quicksilver below $32.50. In addition, the collar doesn’t limit your profit potential unless Quicksilver rallies above $45 per share, a full 32 percent above current levels.