What Is a Zero Cost Collar?
A zero cost collar is a form of options collar strategy to protect a trader's losses by purchasing call and put options that cancel each other out. The downside of this strategy is that profits are capped if the underlying asset's price increases.
- A zero cost collar strategy is used to hedge against volatility in an underlying asset's prices.
- A zero cost collar strategy involves the purchase of call and put options that place a cap and floor on profits and losses for the derivative.
- It may not always be successful because premiums or prices of different types of options do not always match.
Understanding Zero Cost Collar
A zero cost collar strategy involves the outlay of money on one half of the strategy offsetting the cost incurred by the other half. It is a protective options strategy that is implemented after a long position in a stock that has experienced substantial gains. The investor buys a protective put and sells a covered call. Other names for this strategy include zero cost options, equity risk reversals, and hedge wrappers.
For example, if the underlying stock trades at $120 per share, the investor can buy a put option with a $115 strike price at $0.95 and sell a call with a $124 strike price for $0.95. In terms of dollars, the put will cost $0.95 x 100 shares per contract = $95.00. The call will create a credit of $0.95 x 100 shares per contract - the same $95.00. Therefore, the net cost of this trade is zero.
Using the Zero Cost Collar
It is not always possible to execute this strategy as the premiums, or prices, of the puts and calls do not always match exactly. Therefore, investors can decide how close to a net cost of zero they want to get. Choosing puts and calls that are out of the money by different amounts can result in a net credit or net debit to the account.
The further out-of-the-money the option is, the lower is its premium. Therefore, to create a collar with only a minimal cost, the investor can choose a call option that is farther out of the money than the respective put option is. In the above example, that could be a strike price of $125.
To create a collar with a small credit to the account, investors do the opposite—choose a put option that is farther out of the money than the respective call. In the example, that could be a strike price of $114.
At the expiration of the options, the maximum loss would be the value of the stock at the lower strike price, even if the underlying stock price fell sharply. The maximum gain would be the value of the stock at the higher strike, even if the underlying stock moved up sharply. If the stock closed within the strike prices then there would be no effect on its value.
If the collar did result in a net cost, or debit, then the profit would be reduced by that outlay. If the collar resulted in a net credit then that amount is added to the total profit.
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