A Zero-Cost Collar, also known simply as a “collar,” is an options trading strategy that is typically constructed to provide downside protection for an existing position, often with minimal or no net cost (hence the term “zero-cost”). This strategy involves holding the underlying asset (such as stock) while simultaneously buying a protective put option and selling a covered call option. The premiums collected from the sale of the call option generally offset the cost of the put option, resulting in a net cost that is close to zero.
Components of a Zero-Cost Collar
- Underlying Asset: This is the stock or other securities you already own and wish to protect.
- Protective Put Option: This is the option you buy, which gives you the right to sell the underlying asset at a specific price (strike price) before the expiration date.
- Covered Call Option: This is the option you sell, which gives the buyer the right to purchase the underlying asset from you at a specific price (strike price) before the expiration date.
Formulation
The zero-cost collar can be mathematically represented by the combination of asset and options:
How It Works
- Protective Put: Purchasing a put option at strike price \( K_1 \) ensures that if the price of the underlying asset falls below \( K_1 \), you can sell it at \( K_1 \), thus minimizing potential losses.
- Covered Call: Selling a call option at strike price \( K_2 \) generates premium income, which can be used to offset the cost of the protective put. However, this also caps the potential upside, as any appreciation above \( K_2 \) will be relinquished.
Example
Assume you own shares of Company XYZ, currently trading at $100 per share. To implement a zero-cost collar, you might:
- Buy a protective put with a strike price of $95, expiring in three months.
- Sell a covered call with a strike price of $105, expiring in three months.
In this scenario:
- If Company XYZ’s stock price falls to $90, the put option allows you to sell your shares at $95, limiting your loss to $5 per share.
- If the stock price rises to $110, the call option obligates you to sell your shares at $105, thus capping your gain at $5 per share.
Historical Context and Usage
The zero-cost collar strategy became popular during the 1987 market crash, where investors sought ways to protect their portfolios from significant declines. Over time, it has been widely adopted by both individual investors and financial institutions engaged in risk management and hedging.
Comparisons to Related Strategies
- Protective Put: Unlike the zero-cost collar, a standalone protective put involves simply buying a put option without selling a call, thus involving a cost without any offsetting premium.
- Covered Call: Selling a covered call without buying a put exposes the investor to potential downside risks without adequate protection.
Special Considerations
While the zero-cost collar offers balanced risk management with negligible initial outlay, it is crucial to:
- Carefully choose strike prices to balance the trade-off between protection and potential profit.
- Be aware of potential assignment on the sold call option, which might force an early sale of the underlying asset if it trades above the call’s strike price before expiration.
FAQs
Is a zero-cost collar truly 'cost-free'?
Q2: Can a zero-cost collar be used for assets other than stocks? A: Yes, it can be applied to other securities, including commodities and indices, provided the options market for those assets is liquid enough for trading.
Q3: What happens if the asset price stays between the put and call strike prices? A: In this scenario, both options expire worthless, and you retain the underlying asset, having received the protection at minimal or no cost.
References
- Options Trading Strategies
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
- CBOE (Chicago Board Options Exchange) website
Summary
The Zero-Cost Collar is a versatile strategy used extensively in options trading for risk management and hedging. By simultaneously holding an underlying asset, buying a put option, and selling a call option, an investor can limit losses and cap gains with minimal upfront cost. This strategy is especially popular during volatile market conditions and offers a balanced approach for protecting investments.
