Zero cost collar, or a zero-cost option is a trading strategy where investors simultaneously purchase a call and put option. The strategy is mainly used to protect losses. But there is a downside to this strategy.
While a zero cost collar limits maximum losses, it also limits maximum gains. This means that traders won’t make the same gains as when purchasing a normal option.
The strategy is used after holding a long position where the price of the stock experiences substantial gains. The strategy involves buying a protective put and selling a covered call. You might find this strategy under different names, such as a costless collar, collar option strategy, equity risk reversal, and more.
Zero cost collar is a highly complex trading strategy that many experienced options traders use during market volatility.
When Does A Zero Cost Collar Strategy Work?
A zero cost strategy works when a trader wants to protect their asset’s long position in volatile markets. It is mostly used during a bear market, where volatility is at an all-time high. By placing a cap on profits and a floor on losses, traders hedge against the volatility.
As such, this strategy protects from potential short-term downsides. But as mentioned previously, the zero cost collar does limit potential gains.
How To Use A Zero Cost Collar Strategy?
To use a zero cost collar strategy, a trader needs to place an out-of-money put option and sell an out-of-money call option. Both put and call options have the same expiry date, but that doesn’t mean that the strategy will work flawlessly. In some cases, price premiums don’t always match, making it difficult to properly offset the cost.
If you find it difficult to understand what a put and call option is, we have a guide on Call VS Put that explains both positions.
Here is an example of a zero cost collar strategy on a stock XYZ with a price of $20 per share:
Let’s assume that a trader buys 100 shares of XYZ stock with a price of $20. The trader wants to protect his position in the case that the price begins to fall. But the trader also expects gains, so he doesn’t want to sell all of his shares. To protect the long position while also making long-term gains, the trader uses a zero cost collar strategy, or costless collar strategy to minimize risk and profits.
By using the strategy, the trader puts a put option at $20 and a call option at $25. The cost of buying the option is $1. In this case, two things can happen. If the price goes to $30, then profits are limited, because the trader is obliged to sell at $24. If the price goes to $15, then the trader doesn’t suffer significant losses, because they are obliged to sell at $20.
But in rare cases, a third thing can happen. Let’s say that the contract for both put and call options is one year. If the price of the stock doesn’t change (stays $20), the trader loses one year’s worth of premiums.
Should You Use A Zero Cost Collar Strategy?
You should use a zero cost collar strategy if you’re an experienced options trader. A zero cost strategy works really well during market volatility. In this case, the strategy can be a great tool to limit losses.
You shouldn’t use a zero cost collar strategy if you aren’t familiar with call and put options. When determining whether or not to use a zero cost collar strategy, traders need to determine the length of the collar.
This can be six months, one year, etc. What this means is that the trader is giving up future profits or suffering losses if they mistime the length of the collar. But this trading strategy is also proven to protect a trader’s long position.
A zero cost collar, or costless collar strategy is one of the most complex trading strategies. As such, investors should know what they’re doing before implementing one.
Making wrong moves can jeopardize your position. Keeping in mind that it’s difficult to predict the market’s direction, a costless collar trading strategy is viable only for experienced options traders.
Partner at Vega Capital Management - a private funds management company.
An experienced portfolio manager with 10+ years of proven and reputable track record in investment management and financial analysis. Currently, a partner at one of the fastest-growing private fund management companies in southeast Europe, Kiril has been tending to a loyal international base of client-investors and partners. When he is not crunching numbers and increasing his client’s wealth, he reminisces about his Michelin-star restaurant cheffing years and fondness of the culinary arts.