Costless Collar (Zero-Cost Collar) Explained

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Costless Collar (Zero-Cost Collar)

The costless collar, or zero-cost collar, is established by buying a protective put while writing an out-of-the-money covered call with a strike price at which the premium received is equal to the premium of the protective put purchased.

Costless Collar Construction
Long 100 Shares
Sell 1 OTM LEAPS Call
Buy 1 ATM LEAPS Put

Costless collars can be established to fully protect existing long stock positions with little or no cost since the premium paid for the protective puts is offset by the premiums received for writing the covered calls.

Depending on the volatility of the underlying, the call strike can range from 30% to 70% out of money, enabling the writer of the call to still enjoy a limited profit should the stock price head north. This strategy is typically executed using LEAPS® options as the striking price of the call sold can be rather high in relation to the price of the underlying stock.

Limited Profit Potential

Profit is limited by the sale of the LEAPS® call. Maximum profit is attained when the price of the underlying asset rallies above or equal to the strike price of the short call.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Purchase Price of Underlying – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Example

Suppose the stock XYZ is currently trading at $50 in June ’06. An options trader holding on to 100 shares of XYZ wishes to protect his shares should the stock price take a dive. At the same time, he wants to hang on to the shares as he feels that they will appreciate in the next 6 to 12 months. He setups a costless collar by writing a one year JUL ’07 60 LEAPS call for $5 while simultaneously using the proceeds from the call sale to buy a one year JUL ’07 50 LEAPS put for $5.

If the stock price rally to $70 at expiration date, his maximum profit is capped as he is obliged to sell his shares at the strike price of $60. At 100 shares, his profit is $1000.

On the other hand, should the stock price plunge to $40 instead, his loss is zero since the protective put allows him to still sell his shares at $50.

However, should the stock price remain unchanged at $50, while his net loss is still zero, he would have ‘lost’ one year’s worth of premiums of $500 that would have been collected if not for the protective put purchase.

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Note: While we have covered the use of this strategy with reference to stock options, the costless collar is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Summary

By setting up the costless collar, a long term stockholder forgoes any profit should the stock price appreciates beyond the striking price of the call written. In return, however, maximum downside protection is assured. As such, it is a good options strategy to use especially for retirement accounts where capital preservation is paramount.

Many senior executives at publicly traded companies who have large positions in their company’s stock utilize costless collars as a way to protect their personal wealth. By using the zero-cost collar strategy, an executive can insure the value of his/her stock for years without having to pay high premiums for the insurance of the put.

Similar Strategies

The following strategies are similar to the costless collar in that they are also bullish strategies that have limited profit potential and limited risk.

Zero Cost Collar

What is a Zero Cost Collar

A zero cost collar is a form of options collar strategy to protect a trader’s losses by purchasing call and put options that cancel each other out. The downside of this strategy is that profits are capped, if the underlying asset’s price increases. A zero cost collar strategy involves the outlay of money on one half of the strategy offsetting the cost incurred by the other half. It is a protective options strategy that is implemented after a long position in a stock that has experienced substantial gains. The investor buys a protective put and sells a covered call. Other names for this strategy include zero cost options, equity risk reversals, and hedge wrappers.

Basics of Zero Cost Collar

To implement a zero cost collar, the investor buys an out of the money put option and simultaneously sells, or writes, an out of the money call option with the same expiration date.

For example, if the underlying stock trades at $120 per share, the investor can buy a put option with a $115 strike price at $0.95 and sell a call with a $124 strike price for $0.95. In terms of dollars, the put will cost $0.95 x 100 shares per contract = $95.00. The call will create a credit of $0.95 x 100 shares per contract – the same $95.00. Therefore, the net cost of this trade is zero.

Key Takeaways

  • A zero cost collar strategy is used to hedge against volatility in an underlying asset’s prices through the purchase of call and put options that place a cap and floor on profits and losses for the derivative.
  • It may not always be successful because premiums or prices of different types of options do not always match.

Using the Zero Cost Collar

It is not always possible to execute this strategy as the premiums, or prices, of the puts and calls do not always match exactly. Therefore, investors can decide how close to a net cost of zero they want to get. Choosing puts and calls that are out of the money by different amounts can result in a net credit or net debit to the account. The further out of the money the option, the lower its premium. Therefore, to create a collar with only a minimal cost, the investor can choose a call option that is farther out of the money than the respective put option is. In the above example, that could be a strike price of $125.

To create a collar with a small credit to the account, investors do the opposite—choose a put option that is farther out of the money than the respective call. In the example, that could be a strike price of $114.

At the expiration of the options, the maximum loss would be the value of the stock at the lower strike price, even if the underlying stock price fell sharply. The maximum gain would be the value of the stock at the higher strike, even if the underlying stock moved up sharply. If the stock closed within the strike prices then there would be no affect on its value.

If the collar did result in a net cost, or debit, then the profit would be reduced by that outlay. If the collar resulted in a net credit then that amount is added to the total profit.

Zero Cost (Costless) Collar Explained

What Is A Zero Cost Collar?

Table of Contents

A costless, or zero cost, collar is an options spread involving the purchase of a protective put on an existing stock position, funded by the sale of an out of the money call.

The Costless Collar Explained In Detail

Stock investors are exposed to downturns in share prices and often use options to protect against major losses.

The simplest protection method is to purchase puts – usually placed out of the money – enabling the sale of the stock at a predetermined price.

However this insurance comes at a cost: the put option premium paid. To offset this an out of the money call can be sold for a similar price, thus creating the ‘zero’ (net) cost collar.

However there is a payoff – as ever in options trading – as the sold call limits the upside to be enjoyed from the stock held.

Zero Cost Collar Example

Suppose an investor owns 100 IBM shares, valued at $140 per share. Here’s their profit and loss:

Stock P&L Diagram

They are concerned about the risk of their position – their potential loss is, in theory, 100% – and so decide to limit this risk by purchasing a 130 put option contract for $5 per share.

Here’s the new P&L:

Notice how this limits their loss to $15 a share (if the stock falls below $130).

But the $5 put premium has caused the position’s breakeven to rise from $140 to $145. In other words the stock has to rise from its current $140 to $145 to cover the cost of the option protection.

To offset this cost they decide to sell an out of the money 150 call option for $5 (this is a simplified example).

This offsets the purchased put option cost – but means that should the stock rise above $150 it will be ‘called’ away. In other words they would not enjoy any gain above $150.

Profit & Loss: Costless Collar

This is the zero cost, or costless, collar. Both the upside and downside have been limited, to $10 either way.

Pros Of Zero Cost Collars

The downside of a stock position can be protected at zero net cost.

Collars are particularly popular with Company Executives with large portfolios of stock held in trust (ie they can only access it after several years). A costless collar can be used to ‘fix’ the future value of the stock to within a narrow band, thus providing certainty of future payouts.

Unlike many other options spreads an investor will still receive dividends given they own the stock.

Cons Of Zero Cost Collars

The main downside is the limited upside of the stock position once a collar has been put on.

The spread is also complex and involves two options position – this, potentially, incurring significant transaction costs.

It is also unlikely that premiums of suitable puts and calls will be equal as in our example. Indeed out of the money puts often have relatively high implied volatility and hence price and therefore there may be small cost to the position after all.

Conclusion

Costless collars are a great way to limit downside if an investor feels this is more likely than significant upside.

Risk averse stock holders can ‘fix’ their share to within a narrow band at zero cost (at least, in thwory).

But the spread is complex and probably only suitable for more sophisticated options traders.

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