Over the years, 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. (See also: Options for Beginners.)
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. (See also: What Is the Difference Between Risk Tolerance and Risk Capacity?)
When using the zero-cost cylinder, there are risks that are unique to this kind of strategy. That 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. (See also: A Beginner's Guide to Hedging.)
The Bottom Line
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. (See also: Essential Options Trading Guide.)