Zero Cost Collar

The zero cost collar, also known as a costless collar or zero-cost options strategy, is a type of options trading strategy employed to hedge against potential losses without incurring any initial premium cost. This is achieved by simultaneously purchasing a protective put option and selling a covered call option on the same underlying asset. The premiums received from selling the call option offset the cost of purchasing the put option, thus creating a “zero cost” arrangement for the trader.

Overview

A zero cost collar is typically used by investors to lock in a desired range of potential returns while protecting against substantial downside risk. This strategy is particularly popular among equity investors who seek to protect their investments from market volatility while maintaining some upside potential.

The key aspects of a zero-cost collar are:

  1. Protective Put Option: This is a put option purchased by the investor. It gives the investor the right, but not the obligation, to sell the underlying asset at a predetermined price (the strike price) before the option expires. The strike price of this put is typically set below the current market price of the asset to provide a safety net against significant losses.

  2. Covered Call Option: This is a call option sold by the investor. It gives the buyer of the option the right, but not the obligation, to purchase the underlying asset at a predetermined price (the strike price) before the option expires. Selling this option generates a premium that can offset the cost of buying the protective put.

The combination of these two options provides a range of potential outcomes for the underlying asset, with the goal of minimizing the cost of hedging.

Mechanism of a Zero Cost Collar

To illustrate how a zero cost collar works, let’s consider an example involving a stock currently trading at $100 per share. An investor wants to protect their investment from significant losses over the next 6 months while also being willing to cap their potential gains.

  1. Protective Put: The investor buys a 6-month put option with a strike price of $90. This option costs $3 per share.
  2. Covered Call: The investor sells a 6-month call option with a strike price of $110. This option generates a premium of $3 per share.

In this scenario, the cost of purchasing the put option is completely offset by the premium received from selling the call option, resulting in a zero net cost for the hedge.

Payoff Structure

The payoff structure of a zero cost collar can be described as follows:

This structure ensures that the investor’s potential losses are limited while also capping the potential gains.

Advantages and Disadvantages

Advantages

  1. Cost-Effective Hedging: As the name suggests, zero cost collars are designed to provide hedging without initial premium cost, making them an attractive option for cost-conscious investors.
  2. Risk Management: The protective put option limits downside risk, providing a safety net against significant losses.
  3. Simplicity: This strategy is relatively simple to implement and understand compared to other more complex options strategies.
  4. Flexibility: Investors can customize the strike prices and expiration dates of the options to suit their specific risk tolerance and investment goals.

Disadvantages

  1. Capped Upside Potential: The covered call option limits the potential gains an investor can achieve if the underlying asset’s price rises significantly.
  2. Opportunity Cost: By capping the upside potential, investors may miss out on substantial gains if the asset’s price increases beyond the call option’s strike price.
  3. Complexity in Execution: While the concept is simple, executing the strategy requires careful selection of strike prices and expiration dates to achieve the desired hedge.
  4. Margin Requirements: Selling covered call options may require maintaining a margin account, which can involve additional regulatory requirements and risks.

Applications of Zero Cost Collars

Zero cost collars are used by various types of investors and institutions for different purposes:

  1. Equity Investors: Individual investors and portfolio managers use zero cost collars to protect their stock investments from significant downside risk while maintaining some upside potential.
  2. Institutional Investors: Pension funds, insurance companies, and other institutional investors use zero cost collars to hedge their large equity holdings against market volatility.
  3. Corporate Finance: Companies may use zero cost collars to hedge against currency risk, commodity price fluctuations, or interest rate changes that could impact their financial performance.
  4. Portfolio Management: Portfolio managers may employ this strategy as part of their overall risk management and investment strategy to achieve specific return objectives while mitigating risk.

Real-World Example

A notable example of a company utilizing zero-cost collars is Microsoft Corporation. During the 2008 financial crisis, Microsoft employed a zero cost collar strategy to protect its equity investments from market downturns. By using this strategy, Microsoft was able to mitigate the impact of market volatility on its investment portfolio without incurring significant hedging costs.

Conclusion

The zero cost collar is a versatile and cost-effective options strategy that enables investors to hedge against downside risk while maintaining some upside potential. By combining a protective put option with a covered call option, investors can lock in a desired range of potential returns without incurring initial premium costs. While this strategy has its advantages, such as cost-effectiveness and simplicity, it also comes with limitations, including capped upside potential and opportunity costs. Overall, zero cost collars are a valuable tool for managing risk and achieving specific investment objectives in a dynamic market environment.