Over the years the ideas and strategies for trading the options markets have changed at an incredible rate. What worked 10 years ago may not necessarily work today. What this means for traders is that if you want to make money, you have to be willing to adapt.

Here we'll take a look at a simple strategy designed for the modern market: the zero-cost cylinder. (To learn more, see Offset Risk With Options, Futures And Hedge Funds.)

Zero-Cost Cylinder
In a zero-cost cylinder, a trader buys a call and sells a put, or sells a call and then buys a put, with both options out of the money. In buying the call the trader ensures involvement in the increasing price of the option. Selling the put requires that the trader buy the option at the prearranged price if it reaches that point. This strategy is designed to protect the trader from the risk that the underlying asset will fall or rise to a certain level in the future. The strike price is selected so that the premium received from the sale of the option is equal to the premium used in buying the other option. This is how the zero-cost cylinder got its name.

Risks Vs. Rewards
When you are trading options, or almost any asset class for that matter, there will be both risks and rewards. Determining whether a particular strategy is right for you involves weighing these two factors based on your overall level of comfort, your trading objectives and your financial situation. (To read more about risk, see Risk Tolerance Only Tells Half The Story.)

When using the zero-cost cylinder, there are risks that are unique to this kind of strategy. That being said, understanding what the risks are will help you make smarter trading decisions. Some of the different risks involved with using this kind of strategy include:

  1. The hedge is inactive at the two given strike prices, so your hedge is not completely locked-in.
  2. It is possible to incur an opportunity loss if the value of the underlying asset falls outside of your long position.

When you are using the zero-cost cylinder strategy, there are also rewards to make the risk worthwhile. Some of the rewards include:

  1. The cylinder is a zero-cost position.
  2. You can adjust the upper and lower strike prices to meet your needs and expectations, which is important when dealing with options.
  3. The cylinder's hedge position can be offset and unwound when you no longer have the need to hedge. (For more, read A Beginner's Guide To Hedging.)

The zero-cost cylinder provides another way for traders to effectively trade the market while protecting their downside. That being said, there are both risks and rewards to using this kind of strategy. Make sure you are well aware of all the factors surrounding the underlying asset and the options contracts when deciding to undertake a zero-cost cylinder. (For a background on options, check out our Options Basics Tutorial.)

Related Articles
  1. Investing Basics

    3 Alternative Investments the Ultra-Rich Usually Own

    Learn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
  2. Stock Analysis

    6 Hedge Funds With High Dividends

    Understand what value hedge funds can provide investors in the financial sector. Learn about seven hedge funds that pay consistent and high dividends.
  3. Professionals

    Top 5 Highest Paid Hedge Fund Managers

    Understand what a hedge fund is and why hedge fund managers make so much money. Learn about the top 5 highest paid hedge fund managers.
  4. Investing Basics

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  5. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  6. Investing

    Oil: Why Not to Put Faith in Forecasts

    West Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
  7. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  8. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  9. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  10. Professionals

    How Brokers are Candy-Coating Alternatives

    Alternatives have become a sexy choice for many advisors. But they also come with additional risks that are not always clearly spelled out to clients.
  1. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  2. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
  3. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  4. What do hedge fund analysts do?

    A hedge fund analyst primarily provides support to a portfolio manager on how to best structure the hedge fund's investment ... Read Full Answer >>
  5. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  6. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!