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. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  2. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  3. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  4. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  5. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  6. Financial Advisors

    Are Alternatives Right for Your Portfolio?

    Alternative investments are increasingly making their way into retail investors' portfolios. Are they a good fit?
  7. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  8. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  9. Mutual Funds & ETFs

    Scared By ETF Risks? Try Hegding With ETF Options

    With more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
  10. Mutual Funds & ETFs

    ETF Options Vs Index Options

    Investors have much to consider when they’re deciding between ETF and index options. Here's help in making the decision.
  1. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  2. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
  3. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  4. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  5. Can foreign investors invest in US hedge funds?

    U.S. hedge funds are open to accredited investors. When they distribute profits to investors, those proceeds are taxed at ... Read Full Answer >>
  6. Do hedge funds manipulate stock prices?

    Some economics professors think there is evidence of manipulation of certain stocks by hedge funds on key reporting days. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center