Zero-Cost Collar

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21 Aug, 2024

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A zero-cost collar is a financial strategy that investors use to protect themselves against price fluctuations in an underlying asset. It is an options collar strategy that minimizes losses during price declines. It involves the simultaneous purchase of a protective put option and the sale of a covered call option with strike prices that are strategically chosen.

The protective put provides a minimum selling price for the asset, ensuring that losses are limited if the asset's price declines. Moreover, the covered call generates income by selling the call option. However, it restricts the potential upside gains since the investor agrees to sell the asset at a predetermined price if its price rises above the call's strike price.

What Is A Zero-Cost Collar?

A zero-cost collar is an options collar strategy that investors utilize to mitigate potential losses and safeguard their assets against price declines. The method includes purchasing a protective put option and selling a covered call option with strategically chosen strike prices.
The put option offers a minimum selling price for the asset. It ensures that the losses are restricted if the asset's price falls.
The covered call aids in income generation through selling the call option. However, this strategy caps potential gains as investors lose the profits above the call strike price if the asset prices rise significantly.

How Does Zero-Cost Collar Strategy Work?

A zero-cost collar is an options collar strategy that investors employ to safeguard their investments against price fluctuations in an underlying asset. Additionally, it aids in minimizing the initial expenses. This financial technique is particularly beneficial for investors seeking to protect their investments without incurring additional costs.

The Zero-Cost Collar option consists of two primary elements: a protective put option and a covered call option. The protective put option serves as a safety net for the asset. It allows the investor to sell the asset at a predetermined strike price before or at a specified expiration date. If the asset's price declines, the put option would enable them to sell the asset at the agreed-upon strike price, thus limiting their potential losses.

Furthermore, the covered call option generates income for the investor. With a covered call, the investor agrees to sell the asset at a predetermined strike price. In exchange, the investor receives a premium, which serves as compensation.

Factors

Some Zero-Cost collar option factors are:

The choice of the asset is a fundamental factor in this strategy. It could be a stock, commodity, or another financial instrument. The asset's current and expected price movements will influence the collar's design.
Understanding the investor's goals and risk tolerance is essential. Some investors may accept a higher upfront cost for a more comprehensive downside protection. However, others may prioritize generating income and accept more risk.
Anticipating the asset's price volatility is vital in zero-cost collar. High volatility may require adjustments to strike prices or option types to maintain the collar's zero-cost aspect. Market conditions, including interest rates and economic outlook, may influence the cost and availability of options. These market factors can impact the feasibility of implementing this strategy.

Examples

Let us go through the following examples to understand this strategy:

Example #1

Suppose Jake owned 100 shares of ThoughtZone Company, trading at $50 per share. He became worried that the stock might decline soon but still wanted to benefit if it went up. Jake purchased a put option with a strike price of $45 to protect his investment from a downturn. As a result, this put option gave him the right to sell his shares at $45 each, no matter how low the stock's price drops. Simultaneously, he set a call option with a strike price of $55. By doing so, he agreed to sell his shares at $55 each if the stock's price reached that level.

As a result, if the stock price fell below $45, Jake's protective put ensured that he could sell his shares for $45 each, limiting his potential loss. However, if the stock price exceeded $55, Jake's shares would be called away at $55 each due to the covered call. It would limit his potential gain but still provide him with a profit.

Example #2

Suppose Amy owned 100 shares of Avalanche Inc. stock, valued at $60 per share. She was worried that the share price might fall but wanted to profit if it increased. So, Amy decided to create a strategy. First, she purchased a put option for $55, giving her the right to sell her shares at $55 each. Simultaneously, Amy sold a call option for $65, requiring her to sell the shares at $65 if the price increased. The premium she received from selling the call equalized the cost of buying the put, making it cost-neutral initially. This is another Zero-Cost Collar example.

Benefits

The Zero-Cost Collar strategy benefits are:

This strategy can protect against significant downside risk. If the asset's price declines, investors can sell it at the put option's strike price, limiting potential losses.
It is designed to be cost-neutral at the initiation. This implies that the premium received from selling the call option balances the cost of purchasing the put option. Thus, there is no initial investment. Investors can gain downside protection without spending additional money.
Selling the covered call generates income in the form of a premium. This income can be attractive for income-seeking investors. It can help counterbalance other investment costs or provide additional income streams.
Investors can customize the strategy to suit their risk tolerance and investment objectives. Through this versatile strategy, they can choose strike prices, expiration dates, and assets that align with their needs.
The zero-cost collar is an effective risk management tool. This instrument is beneficial if an investor wants to protect an existing portfolio or investment without liquidating it.

Risks

The Zero-Cost Collar strategy risks are:

This strategy limits potential gains. Investors may restrict their profit potential if the asset's price rises significantly by selling a covered call with a strike price. If the asset experiences a substantial price increase, investors will miss out on those gains above the call strike price.
Options have expiration dates. If the asset's price moves unfavorably and the protective put expires out of the money, investors may not fully recover the losses, even with the put option in place.
Trading costs may be associated with buying and selling options, like commissions and bid-ask spreads. These expenses may affect the zero-cost collar strategy's overall cost neutrality.
It requires active monitoring and adjustments. Market conditions and the asset's price may fluctuate, requiring investors to decide to adjust strike prices or exit the strategy.

Zero-Cost Collar vs Bull Spread

The differences between the two are as follows:

#1 - Zero-Cost Collar

This strategy is used for hedging or protecting an existing investment against downturn risk while allowing for some upside potential.
It is designed to be cost-neutral upfront. However, it limits potential gains because the covered call sets a maximum selling price for the asset.
This technique is a risk management strategy. It is suitable for investors concerned about protecting their investments from significant losses.
This collar is often used in a bearish or uncertain market when investors want to safeguard their portfolios against potential downturns.

#2 - Bull Spread

Bull spread is used when an investor expects a moderate increase in the underlying asset's price. It involves buying a call option with a lower strike price and simultaneously selling one with a higher strike price.
These spreads have a net upfront cost because the long call costs more than the premium from selling the short call. They offer a limited profit potential, which is the difference between the strike prices minus the net cost.
They do not provide downside protection and can result in a loss equal to the net cost if the asset's price declines significantly.
The spreads are used when investors are moderately bullish on the asset and want to profit from its potential price increase.

Frequently Asked Questions (FAQs)

1. Is a Zero-Cost Collar the same as a risk-free collar?

This collar is not the same as a risk-free collar. Although both strategies aim to limit downturn risk, they differ in their cost structure. A Zero Cost is designed to be cost-neutral at the initiation. It protects without an upfront cost. However, a risk-free collar involves a net premium expense as it prioritizes creating price protection with options while accepting a cost for that protection.

2. Are there tax implications with a Zero-Cost Collar?

Yes, there can be tax implications associated with this collar. It depends on the jurisdiction and individual circumstances. When holders sell a covered call as part of the collar strategy, they may incur capital gains taxes if the call option is exercised and they sell the underlying asset. Additionally, the treatment of premiums received from selling the call option and any gains or losses from the collar may have tax implications.

3. Can a Zero-Cost Collar be applied to any asset?

This strategy can apply to several asset types, including stocks, commodities, and exchange-traded funds. However, there must be an active options market for the selected asset. The flexibility in the strategy lies in its adaptability to different assets.