A trader’s guide to the zero-cost collar options strategy
We look at zero-cost collars and how traders can utilise them in their trading.
What is a zero-cost collar strategy?
A zero-cost collar is an options collar strategy that is designed to protect a trader’s potential downside. It does this by utilising call and put options which, in effect, cancel each other out.
While it will put a cap on potential losses arising from the trade, it will also cap potential profits. It is designed to hedge against volatility in the underlying price of the asset.
When to use the zero-cost collar strategy
The strategy involves the purchase of a put option and the use of an out-of-the-money covered call. The strike price of the call means that the premium received is equal to premium of the purchased put.
A collar is used to protect existing long positions with relatively low cost, as the premium paid for the put is offset by the premium received on the covered calls.
Zero-cost collar strategy example
The pay-off for a zero-cost collar is seen below:
If stock ABC is trading at £10, an options trader with 100 shares of the firm is looking to protect his holding if the price of the shares begins to fall. However, he wishes to hold on to the shares as he expects further gains in the year to come. The trader creates a zero-cost collar by writing a one year £12 call for £1 while also using the proceeds from the sale of the call to buy a one year £10 put for £1.
If the shares rise to around £14, then the maximum profit is limited since the trader is obliged to sell the shares at the strike price of £12. With 100 shares, the profit made on the trade is £200. If the shares fall to £8, then the loss is zero since the put will allow the trader to sell his shares at the £10 specified in the put option.
Disadvantages of zero-cost collar strategy
While the transaction itself is cashless, it does involve an opportunity cost of forgoing investment gains. Investors also face the problem of determining how long to leave the collar in place, which entails the use of market timing. Choosing the wrong length of time could mean giving up future profits, or suffering a loss in the end anyway.
Given that stock markets tend to rise in the long-term, and investors and traders are poor at judging market direction in the near term, many investors would be best served by avoiding complex strategies. But for those experienced at options trading a collar strategy may prove fruitful.