Zero Cost Collar

What is a zero cost collar?

It is an options trading strategy used by derivatives traders. The strategy aims to offset volatility infused downside risks. The traders using this strategy place a limit on probable maximum loss and maximum possible gains. It is done by purchasing a cap and floor price for the derivative instrument. The zero-cost collar strategy is generally used in bearish markets by removing ‘out of money options from the portfolio. Hence, it is also referred to as a costless collar strategy sometimes.

Frequently Asked Questions (FAQ)

How does costless collar strategy work?

Investors use the zero-cost collar or costless collar strategy to place a limit maximum probable loss. However, it also caps the maximum potential gain they can make.

It is a protective derivative tactic often implemented when a long position in security experiences significant gains.

Once such gains are achieved, and the market turns bearish, investors to protect their earnings, buy a protective put option (right not obligation to sell underlying) and sell an equally covered call (right not obligation to buy underlying) option.

Usually, the investor buys an out of money put option and at the same time sells or writes, and out of money call option. Both of these derivatives contain the same expiration date.

The maximum profit using this strategy is thus the difference between the options strike price and the purchase price of the underlying security.

Often options investors and traders use this strategy when the underlying security price is greater than the strike price call option sold.

Therefore, the investor’s maximum loss is the purchase price of underlying stock minus strike price put option purchased. Also, the maximum possible gain is the difference in underlying security price, which is lesser than the strike price of the purchased call option. 

The costless collar strategy attracts market players looking to zero down costs of execution. However, it may not always zero down the entire costs as premiums of the call option and put option may not always match.

Derivative traders still use the strategy and enter a trade with either a net credit or debit caused by premiums. In a net debit trade, he/she would sell the call option out-of-money, and loss would be more than the bought put options’ strike and underlying price difference. Alternatively, in a net credit trade, he/she would purchase a put option that is more ‘out-of-money than the call option sold.

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Example

Let us consider; an investor Mr Bigbill owns 100 shares of Aplle Inc. He has bought them for US$90. At present, due to a macro-economic policy affecting technology companies, Apple Inc. securities start trading lower, at US$85. Now, to protect against further downside risk, Mr Bighill will set up a zero-cost collar. He will purchase a put option at an US$83 strike price on Apple Inc. shares and sell a call option on the same with a US$92 strike price.

Now let’s say at that time, the call options got sold at a premium price of US$2 per share and put options got purchased at a premium price of US$2 per share. So it means that the investor struck trade at zero costs or was a costless trade for Mr Bigbill.

Now, if the security expires for US$92 or more, then Mr Bigbill will achieve a maximum profit of US$200. It is because his 100 underlying shares will gain US$2 (i.e. US$92 – US$90).

On the other hand, if shares expire for US$83 or slightly lower, then Mr Bigbill will experience a maximum loss of US$700. It is just 100 underlying securities of Apple Inc. multiplied by US$7 (i.e. US$90 –US$83).

Therefore, using the costless collar, Mr Bigbill will experience taking a protective position at zero costs. It will also protect Mr Bigbill from any further downside risks.

Which are other similar strategies?

Zero collar cost is just one options trading strategy, a few other similar strategies to a costless collar that help limit risks even though limiting profit potential are-.

• Collar trading strategy is set up by holding shares of the underlying security alongside buying put options and selling calls on the same share to create protection against the holding. Here, puts and calls traded are both out-of-money. These also have the same expiration month and are essentially equal in the number of shares.
• Bull put strategy is useful when derivative traders assume that the underlying security price will rise in the short term but only reasonably. The bull put spread strategy of options trading is also called a bull put credit strategy, as traders receive credit after striking the trade. The trader uses two put options and creates a range having a high and a low strike price.
• Bull call strategy- another protective options trading strategy is employed when a derivative trader thinks the underlying security price will rise reasonably in the near term. It is implemented using an at-the-money call option alongside a higher striking out-of-money call option written on the same underlying shares and with the same expiration month. It is another strategy that limits losses.

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What are pros and cons of zero cost collar?

The benefits of using a costless collar or a zero-cost collar strategy are –

• It limits the downside risks involved in a stock trade position by protecting at zero net cost.
• The large portfolio derivative traders often use collar strategies as they are used to limit the future value of stock within a narrow probable band of fluctuations.
• Unlike the other options trading strategies, an investor will receive dividends on the underlying shares held.

On the flip side, the major pullbacks of zero cost collar are-

• It limits the upside a stock position can reach to protect from downside risks, so it is slightly conservative.
• It is a complex options trading strategy having two derivative positions, thus come with implicit transaction costs.
• Often, traders do not find suitable calls and put with matching premiums to achieve a costless collar.
• Out of money puts are often priced relatively higher due to the implicit volatility, thus generating a small cost on the trade position undertaken.