What Is a Zero-Cost Collar?

The zero-cost collar is an option collar method that lowers your losses. To execute it, you must acquire a long-put option whose price cancels out the short-call option you sell. This strategy’s drawback is that gains are limited if the cost of the underlying asset rises.

Understanding Zero Cost Collar

A zero-cost collar method entails spending money on one half of the plan to balance the cost of the other half. It’s a defensive options tactic you use following a significant gain in your long stock position.

You utilize an owned stock, purchase a protective put, and sell a covered call to establish the position. This tactic is known as hedge wrappers, stock risk reversals, and zero-cost options.

Buying an out-of-the-money put option forces the seller to buy the underlying at strike; concurrently, you sell an out-of-the-money call option with the same expiry date, hoping the buyer will purchase the underlying at strike. This allows you to execute a zero-cost collar.

Take the case of buying a stock for $100 as an example. After a month, it was worth $120 per share. You buy a put option with a strike price of $115 for $0.95 and sell a call option with a strike price of $124 for $0.95. This way, you lock in some gains. To give you an idea of how much the put will cost, $0.95 times 100 shares per contract equals $95.00. The call will make a credit of $95.00, which is $0.95 times 100 shares per contract. Because of this, the deal has no net cost, and you’ve locked in gains.

Making Use of the Free Collar

Because the premiums, or prices, of the puts and calls only sometimes match precisely, executing this approach is only occasionally viable. As a result, investors are free to choose the degree of proximity to a net cost of zero. Selecting calls and puts that are different amounts out of the money may cause the account to be net credited or debited.

The option’s premium decreases with an increasing out-of-the-money position. Consequently, you may choose a call option that is more out of the money than the corresponding put option to make a collar for the least amount. For the example above, there may be a $125 strike price.

You choose a put option farther out of the money than the corresponding call to establish a collar that results in a bit of credit to the account. That may be a strike price of $114 in the given case.

The profit would be decreased if the collar resulted in a net cost or debit. In contrast, the amount contributed to the overall profit if the collar produced a net credit.

Even if the underlying stock’s price drops significantly, the maximum loss at option expiry would be the difference between your purchase price and the stock’s value at the lower strike price. Even in the event of a substantial increase in the underlying stock, the maximum gain would be the difference between the buy price and the stock’s value at the higher strike. If the stock closed inside the strike price, the options would expire, so it wouldn’t have any impact on you.

Is it Free to Wear a Costless Collar?

The collar is free to buy and sell, but other charges and expenses may be involved with the transaction.

What Advantage Does a Free Collar Offer?

If the market moves negatively, this method reduces your losses. Still, selling the call reduces your earnings as well. Unless the buyer decides not to exercise, it is the best price you can acquire for your shares.

The Risk Reversal: What Is It?

A zero-cost collar is the same tactic as risk reversal. You sell a call and purchase a put on an extended position to reduce the possibility of suffering significant losses.

The Final Word

The zero-cost collar is an extended position technique that shields you against significant losses in the event of a market decline. You purchase a put with a lower strike price and sell a call with a higher strike price to establish the collar. This reduces your profit potential on the underlying asset if the call purchaser exercises and provides you with a safety net.

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Updated on May 20, 2023: This article’s previous version said incorrectly that a trader had to purchase both call and put options to establish a zero-cost collar. Since a trader bought a call and sold a put to create the collar, this was untrue.

Conclusion

• One way to protect against the price volatility of an underlying asset is to employ a zero-cost collar method.
• To implement a zero-cost collar strategy, sell a short call and purchase a long put, setting a floor and ceiling on the underlying gains and losses.
• Because the premiums or prices of various option types don’t always match, it could not be successful.