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.

RELATED TERMS
  1. Collar Agreement

    A collar agreement is a series of financial transactions aimed ...
  2. White Collar

    White collar is the working class that commonly works office-based ...
  3. Interest Rate Collar

    An interest rate collar is an investment strategy that uses derivatives ...
  4. Blue Collar

    A working-class person historically defined by hourly rates of ...
  5. Fence (Options)

    A fence or collar is an option strategy that establishes a trading ...
  6. Blue Collar Trader

    A trader who has another source of income, and does not trade ...
Related Articles
  1. Investing

    Minimize Risk With The Long Collar

    Think your favorite stock is on the way down? This simple option-trading strategy can help you manage your risks without selling the stock.
  2. Insights

    Blue Collar vs. White Collar: Different Social Classes?

    Learn about the terms "blue collar" and "white collar," the connotation each carries for social class and type of labor performed, and how it's changing.
  3. Investing

    Long on Oil? Hedge Falling Oil Prices with Options

    With no end to the oil slump in sight, here are some risk management strategies using options to protect your oil positions.
  4. Investing

    4 Ways to Diversify a Concentrated Stock Position

    Owning too much stock concentrated in one company exposes an investor to significant risk. Find out four strategies to diversify and protect your portfolio.
  5. Trading

    Index Options: A How-To Guide

    Index options, financial derivatives that derive their value from a stock index, can provide stability and peace of mind for less risky investors.
  6. Personal Finance

    Blue Collar Back-to-School Advice

    Blue collar jobs can offer a great income and benefits without the cost of a four-year degree.
  7. Trading

    Understanding Bull Spread Option Strategies

    Bull spread option strategies, such as a bull call spread strategy, are hedging strategies for traders to take a bullish view while reducing risk.
  8. Trading

    Getting Acquainted With Options Trading

    Learn about trading stock options, including some basic options trading terminology.
  9. Trading

    Three Ways to Profit Using Call Options

    A brief overview of how to provide from using call options in your portfolio.
  10. Trading

    4 Popular Options Strategies for 2016

    Learn how long straddles, long strangles and vertical debit spreads can help you profit from the volatility that stock analysts expect for 2016.
RELATED FAQS
  1. What is the difference between in the money and out of the money?

    Learn about how the difference between in the money and out of the money options is determined by the relationship between ... Read Answer >>
  2. How do I set a strike price for an option?

    Learn about the strike price of an option and how to set a strike price for call and put options depending on risk tolerance ... Read Answer >>
  3. When is a put option considered to be "in the money"?

    Learn about put options, what they are, how these financial derivatives operate and when put options are considered to be ... Read Answer >>
Hot Definitions
  1. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  2. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  3. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  6. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
Trading Center