The zero cost collar is an option strategy where an investor holds a long position in a stock while simultaneously selling an “out-of-the-money” call option to pay for an “out-of-the-money” put option.
This strategy is used in bear markets to protect investors from downside risk. After reading this article, investors will be able to implement this strategy into their own investing playbook to protect their portfolios from a falling market.
By using this strategy, an investor places a limit on his potential maximum loss but also places a limit on his potential maximum gain.
An investor’s maximum profit from this strategy is the strike price of the sold call option minus the purchase price of the underlying stock. This occurs when the price of the underlying stock is greater than the strike price of the sold call option.
An investor’s maximum loss is the purchase price of the underlying stock minus the strike price of the bought put option. This occurs when the price of the underlying stock is less than the strike price of the bought call option.
The zero cost collar is appealing to investors because it is a strategy that can be used that costs zero dollars to execute. However, it does not always work out like this since the premiums of the call option and put option do not always exactly match.
Investors will still use this strategy even when the premiums do not match up. If this happens, investors will enter the trade with either a net credit or debit from the premiums.
If an investor were to enter the trade with a net debit, then he would sell a call option further “out-of-the-money” than the put option being bought. Alternatively, if an investor were to enter the trade with a net credit, then he would buy a put option further “out-of-the-money” than the call option being sold.
To better understand all of this information, let’s look at an example of a zero cost collar.
Assume an investor owns 100 shares of stock XYZ that he bought at a price of $90. Currently, the stock is trading at $85. To protect against further downside risk, the investor sets up a zero cost collar by purchasing a put option with a strike price of $83 and selling a call option with a strike price of $92.
Assume the call options were sold at a premium price of $2 per share. Assume the put options were bought at a premium price of $2 per share. Therefore, the investor enters the trade with zero costs.
If the stock expires at $92 or above, then the investor will achieve the maximum profit of $200, or 100 shares x (92 – 90).
If the stock expires at $83 or below, then the investor will experience his maximum loss of $700, 100 shares per contract x (90 – 83).
From this example, an investor can see how a protective position can be established at zero cost. This is an effective strategy to use when an investor wants to protect his stock position from further downside risk.