What is a 'Zero Cost Collar'

A zero cost collar is a form of options collar strategy where the outlay of money on one half of the strategy offsets 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.

By doing so, the investor locks in both the maximum gain and maximum loss for the underlying stock. Typically, collars are used to limit downside risk, but since they also limit upside potential they are frequently used in falling or bear markets. It allows the investor to protect unrealized gains without having to sell the stock right away. This has several benefits, including allowing for the capture of dividends and possibly deferring a taxable event until a later date, and more likely the next tax year.
 

BREAKING DOWN 'Zero Cost Collar'

To implement a zero cost collar, the investor buys an out of the money put option and simultaneously sells, or writes, an out of the money call option with the same expiration date.

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 = $950.00. The call will create a credit of $0.95 x 100 shares per contract - the same $950.00. 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, the lower 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 affect 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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