A zero cost collar is an options collar strategy designed to limit potential losses on an existing position. By selling a short call option and buying a long put option, you can create a protective mechanism at no net cost. However, this strategy also caps your potential profits should the underlying asset’s price increase.
Key Takeaways
- A zero cost collar helps hedge against volatility in the prices of an underlying asset.
- The strategy involves selling a short call and buying a long put, creating a cap and floor on potential profits and losses.
- The success of this strategy can vary based on whether the premiums of the options align to create a net zero cost.
Understanding Zero Cost Collar
A zero cost collar strategy is typically employed after experiencing significant gains from a long position in a stock. To implement this, an investor uses their stock, buys a protective put, and sells a covered call, creating a balance where the costs cancel each other out. This is also known as zero cost options, equity risk reversals, and hedge wrappers.
To execute a zero cost collar, you would buy an out-of-the-money put option and sell an out-of-the-money call option with the same expiration date.
For example, suppose you purchased a stock for $100. One month later, it trades at $120 per share. To lock in gains, you buy a put option at a $115 strike price for $0.95 and sell a call option at a $124 strike price for $0.95. The costs of the put and call balance out, resulting in a zero net cost.
| Purchase Price | Price | Strike Price | Result | |
|---|---|---|---|---|
| Call Option | $95 (credit) | — | $124 | $14 profit |
| Share Price | $110 | $120 | — | — |
| Put Option | $95 (debit) | — | $115 | $5 profit |
Using the Zero Cost Collar
The optimal execution of this strategy depends on the alignment of the premiums of the puts and calls so they cancel each other out. If exact matches are unavailable, investors can choose options that are further out-of-the-money, affecting the total net cost or credit of the strategy.
The flexibility in choosing differing strike prices allows you to create a minimal cost collar or even a small credit. However, the success and cost-efficiency of the collar depend on these strike price selections.
Is a Costless Collar Really Costless?
While the collar itself is costless in terms of options premiums, be mindful of additional fees and potential transaction costs that may be associated with executing the trade.
What Is the Benefit of a Zero Cost Collar?
This strategy minimizes your losses in a downturn but also limits your potential gains by capping the maximum profit you can achieve through the sold call option.
What Is the Risk Reversal?
Risk reversal is another term for the zero cost collar strategy. It aims to mitigate risks associated with substantial losses by combining a sold call option with a purchased put option on a long position.
The Bottom Line
The zero cost collar is a pragmatic strategy to hedge your investments against significant downturns while ensuring some profit is locked in. Buying a lower strike price put and selling a higher strike price call creates a safety net, though it also caps potential gains. Other, more sophisticated risk management strategies like the fence strategy could also be explored for greater flexibility and control.
Mastering the zero cost collar can be a potent tool in your trading arsenal, providing peace of mind in an unpredictable financial landscape.
Related Terms: protective put, covered call, hedge wrappers, equity risk reversals, out-of-the-money options, options premium.
