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.
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:
- The hedge is inactive at the two given strike prices, so your hedge is not completely locked-in.
- 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:
- The cylinder is a zero-cost position.
- You can adjust the upper and lower strike prices to meet your needs and expectations, which is important when dealing with options.
- 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.)