What is Zero Cost Collar Strategy? How Does it Work?

In options trading, investors make use of different strategies in order to increase profits or reduce risk of losses. A zero-cost collar strategy is one of the strategies that traders use to hedge against the risk of potential losses. It is also referred to as zero-cost options, equity risk reversals and hedge wrappers.

This strategy is a protective options strategy. It is put to use after a long position in a stock which has had substantial gains.

Continue reading to know more about the zero cost collar strategy.

How does a Zero Cost Collar Strategy work?

Investors might often face a downturn in their stock market investments. In response, they resort to trading with options to reduce the chances of potential losses. A zero cost collar strategy is designed for market volatility and an underlying asset.

In this strategy, investors who hold shares of a particular stock buy an out-of-the-money put option with a strike price lower than the stock’s market price. Simultaneously, they sell an out-of-the-money call option with a higher strike price but the same expiration date. This strategy is suitable for taking a long position on stocks that have seen massive gains.

By using the zero cost collar strategy, traders offset the premium that they had to pay as a put buyer by selling a call option. Through this, they create a zero (net) cost collar. Utilising these two options, the investor puts a floor on the possible losses. However, along with limiting potential losses, this strategy also limits the potential profits that an investor can make.

When to use the zero cost collar strategy?

There are times when the price of a sṭock that you own increases quite substantially. You may not want to sell it immediately because you feel that its price may go even higher. However, along with the bullish sentiment, you are also having doubts about the possibility of a bearish market and potential losses.

In such a situation, you may try to prevent any potential losses. The zero-cost collar strategy serves this very purpose. With it, you buy an out-of-the-money put option to limit your potential losses. However, you are also not willing to waste precious money on paying the premium for buying put options. Thus, you get the premium money back by simultaneously selling an out-of-the-money call option. Hence, you have successfully hedged your stock at no cost.

In this strategy, a collar is being used to protect one’s existing long term gains with very little or no cost. The premium received needs to be equal to what an investor is paying for buying put options.

Example of a zero cost collar strategy in action

Let us assume that you hold 100 shares of company ABC. The current price of the asset is ₹2,000 per share which you bought at ₹1,200 per share. You are still expecting it to go up in the long term. However, you are also having a fear that it may fall in the short term. Therefore, you resort to using options as a hedging medium to hedge your investment.

You decide to use the zero cost collar strategy to protect your investment against a bearish market. To do this, you need to buy a put option at a strike price of ₹1,500 and a premium of ₹50 for 3 months. To offset your cost, you write an out-of-the-money call option at a strike price of ₹2,500 and a premium of ₹50 for 3 months. 

Now let us consider some different market scenarios and the resultant profits that you might make from them.

• If the market prices move sideways and stay between ₹1,500 and ₹2,500, then you do not have to exercise your options as you stand to make no profits out of it. However, you hedged your investment for 3 months at no cost.
• In case the price rises to more than ₹2,500, you have to sell the stock at ₹2,500. However, since you are selling the stock at a higher price, you still will be making a handsome profit out of it.
• Let us say that the stock price crashes below ₹1,500. Then, this strategy will give you double profits that can offset most or all of the losses due to the downside movement of the stock. 

Here the call option will expire worthless, but you can keep the premium as profit. In addition to that, the put option that you had bought goes up in value, giving you major gains when you encash it. This becomes your second profit in such a scenario. The third source of profit is the stock price appreciation that has risen significantly from your purchase price.

Thus, by using zero cost collar strategy you are limiting your potential losses which act as insurance for a bearish market. However, along with that, you are also limiting your profits when using this strategy.

Benefits of zero cost collar Strategy

• Minimises risk

This strategy substantially minimises the potential risks if stock prices go down against your bullish prediction. In such a scenario, you do not have to accept losses thus incurred by selling the stock at a lower market price. 

• Investments can be retained

As an investor, you have no need to hurry regarding selling a stock when you are expecting the stock prices to rise further. Even when the stock prices fall a little in the short term, you have nothing to worry about and can retain your investment if it rises in value in the near future.

• Zero cost

In a zero-cost collar strategy, as the name suggests, you do not have to pay anything extra for the protection that it provides. By purchasing a put option, you get to secure your stock investment and simultaneously offset premium costs by selling a put option. Thus, this risk management strategy comes at zero cost.

• Reduces anxiety over losses

The thought of incurring a loss leads to a lot of anxiety among investors. Zero cost collar strategy gives you that mental relaxation that you will not be incurring any large-scale losses from stocks you hold. You can be free from any worries even when you hold on to the shares hoping for a bullish market.

Downsides of Zero Cost Collar Strategy

Every strategy used for trading options has its share of disadvantages, and so does the zero-cost collar strategy. Some major downsides of using this strategy are given below:

• The transaction can be cashless, but the opportunity cost of missing investment gains can be quite high.
• One of the most difficult tasks for an investor in this strategy is to correctly ascertain how long to leave the collar in place. The timing is based on analysis and market conditions; something that is a challenge for inexperienced investors to figure out.
• Since option payoff profiles tend to be nonlinear, the range of outcomes can be asymmetric. As a result, this hedging strategy exposes investors to higher chances of losses than gains.
• Options strategies like the zero-cost collar strategy are quite complex and difficult to comprehend. Thus, this might prove to be a complicated strategy for new traders.

Things to consider before using the zero cost collar strategy

There are certain factors that you must take into account when using the zero-cost collar strategy. Some of them are given below:

• Limited earnings

Zero cost collar strategy limits your losses and along with that your potential earnings. Thus, you may not have to sell the stock at prices lower than the current market prices. However, you also cannot partake of higher profits from a rising market price. You will only be getting the price that is specified in your call option contract and no more.

• Additional expenses

You must remember that despite this strategy incurring no costs, you might still have to pay brokerage fees and other costs. If these charges consist of a sizable financial chunk, it may result in losses.

• Timing

When you resort to a zero cost collar strategy, you can only sell your stock at the expiration date and not before that. Thus, you cannot take advantage of any price rise that happens in the interim period.

• Possibility of no earnings

You must remember that though a zero cost collar strategy will protect your investmenṭ from incurring large-scale losses, you may get zero earnings in unfavourable market conditions.

Final Words

A zero cost collar strategy provides protection for your stock or index investments without any additional costs. This strategy is becoming more and more popular amongst investors since it lets them make profits on an appreciating asset while mitigating the risk of losses. Despite the numerous advantages of this strategy, it comes with several disadvantages which investors need to be aware of.

Frequently Asked Questions