Zero cost collar

What Is a Zero Cost Collar?

A zero cost collar is an options strategy designed to protect an investor's gains in an underlying asset, typically a stock, while simultaneously financing the cost of that protection. This hedging technique involves simultaneously buying a put option and selling a call option on the same underlying asset with the same expiration date. The "zero cost" aspect is achieved when the option premium received from selling the call option approximately offsets the premium paid for buying the put option. This strategy falls under the broader category of derivatives and is a common approach in risk management for existing stock positions.

History and Origin

The evolution of standardized options contracts is closely tied to the advent of organized exchanges. Before 1973, options were primarily traded over-the-counter with varying terms and liquidity. The launch of the Chicago Board Options Exchange (CBOE) on April 26, 1973, marked a pivotal moment, introducing standardized, exchange-listed stock options. This standardization, which included uniform strike prices and expiration dates, facilitated the development of more complex multi-leg strategies like the zero cost collar. While the zero cost collar itself doesn't have a single inventor or specific historical event marking its inception, its practicality became apparent as the options market matured and strategies for portfolio protection and income generation gained popularity. The CBOE's establishment provided the necessary infrastructure for such sophisticated strategies to become accessible to a wider range of investors.¹⁴, ¹⁵, ¹⁶

Key Takeaways

A zero cost collar combines the purchase of a put option and the sale of a call option on the same asset.
Its primary goal is to protect gains in a long stock position and define a range of potential outcomes.
The strategy aims for a net zero or near-zero premium, meaning the cost of the put is offset by the income from the call.
It limits both downside risk and upside potential of the underlying equity during the options' life.
Zero cost collars are a form of hedging used by investors to manage portfolio risk.

Formula and Calculation

The "zero cost" aspect of a zero cost collar refers to the net premium of the options involved. It is achieved when the premium paid for the protective put option is approximately equal to the premium received from selling the covered call option.

The calculation for the net premium of a zero cost collar is:

\text{Net Premium} = \text{Premium Paid for Put Option} - \text{Premium Received from Call Option}

For a true zero cost collar, the investor selects the strike price and expiration date of the put and call options such that the total option premium from the sold call offsets the total premium of the purchased put. This means the Net Premium is approximately zero. If the premium from the call is higher, it results in a net credit; if the put premium is higher, it results in a net debit.

Interpreting the Zero Cost Collar

Interpreting a zero cost collar involves understanding the defined risk and reward profile it establishes for a stock position. By implementing this strategy, an investor essentially creates a "collar" around their existing shares, setting a floor and a ceiling for their potential profit and loss over a specified period. The purchased put option provides a price floor, protecting the investor from significant downside movement below the put's strike price. Simultaneously, the sold call option creates a price ceiling, meaning any capital appreciation above the call's strike price will be forgone.

The interpretation hinges on the investor's outlook and risk tolerance. It signifies a desire to protect accumulated gains and limit risk management to a known range, even if it means capping potential upside. This can be particularly appealing for long-term investors in a portfolio who wish to guard against short-term volatility without selling their shares outright.

Hypothetical Example

Imagine an investor owns 100 shares of XYZ stock, currently trading at $100 per share. They are concerned about potential short-term downside but want to hold onto the shares for long-term growth. They decide to implement a zero cost collar:

Buy a Put Option: The investor buys one XYZ $95 put option with three months until expiration for an option premium of $3 per share (total cost: $300). This sets a floor, protecting their equity from falling below $95.
Sell a Call Option: To offset the cost, the investor sells one XYZ $105 call option with three months until expiration for a premium of $3 per share (total income: $300). This caps their upside at $105.

Since the premium paid for the put ($300) is offset by the premium received from the call ($300), the net cost of establishing this collar is zero.

Scenario 1: Stock price falls to $90.
The investor's shares are worth $9,000. However, the put option is "in the money" by $5 per share ($95 - $90 = $5). The investor can exercise the put, selling their shares at $95. The call option expires worthless. Net outcome: The downside was limited to $95 per share, preserving significant value compared to letting the stock fall to $90.

Scenario 2: Stock price rises to $110.
The investor's shares are worth $11,000. However, the call option is "in the money" by $5 per share ($110 - $105 = $5). The investor will likely have their shares called away at $105. The put option expires worthless. Net outcome: The investor sells their shares at $105, realizing capital appreciation up to that point, but forgoing further gains above $105.

Scenario 3: Stock price remains at $100.
Both the put and call options expire worthless. The investor retains their shares and has incurred no net cost for the protection.

Practical Applications

Zero cost collars are primarily used by investors who hold a long position in a stock or a basket of stocks and wish to protect themselves against a potential downturn without selling their shares outright. This strategy is particularly relevant for:

Long-Term Investors: Those with significant embedded gains in an underlying asset who want to lock in a portion of those profits. It allows them to maintain ownership for tax purposes or for future participation in gains above the put strike price, while limiting immediate downside risk.
Shareholders of Highly Appreciated Stocks: Individuals with concentrated positions in a single stock, perhaps from employer stock options or early investments, can use a zero cost collar to diversify their risk management without incurring a significant transaction cost.
Portfolio Managers: Professional portfolio management often employs collars to manage the overall risk of equity portfolios, especially in uncertain market conditions.
Pre-Event Hedging: Ahead of significant company announcements (e.g., earnings reports, FDA approvals) or broader market events, investors might use a zero cost collar to mitigate event-specific price volatility.
Estate Planning: For large, illiquid stock holdings that need to be held for a period, a collar can protect the value of the asset for beneficiaries.

Investors considering options strategies, including zero cost collars, should review the "Characteristics and Risks of Standardized Options" disclosure document provided by The Options Clearing Corporation and the U.S. Securities and Exchange Commission, which outlines the complexities and potential risks involved.⁹, ¹⁰, ¹¹, ¹², ¹³ Retail investors can find general discussions on using options for income and risk reduction on resources like the Bogleheads Wiki.⁵, ⁶, ⁷, ⁸

Limitations and Criticisms

While a zero cost collar offers valuable hedging benefits, it comes with several limitations and criticisms:

Capped Upside Potential: The most significant drawback is that the sold call option limits the investor's ability to participate in substantial capital appreciation above the call's strike price. If the stock performs exceptionally well, the investor misses out on further gains beyond the call strike.
Opportunity Cost: In a strong bull market, the collar can prove costly in terms of lost opportunity, as the gains forgone might outweigh the protection provided.
Volatility and Time Value Decay: The "zero cost" aspect relies on matching the premiums. Changes in implied volatility between the put and call options, or the natural decay of time value as expiration approaches, can affect the effectiveness and ongoing neutrality of the collar.
Early Assignment Risk: The sold call option carries the risk of early assignment, especially if the stock price rises significantly above the call strike and the option is deep "in the money." While rare for standard options, it can disrupt the intended strategy.
Liquidity: For less liquid stocks, finding actively traded options to construct a true zero cost collar can be challenging, leading to wider bid-ask spreads and less favorable pricing.
Complexity: Compared to simply holding shares or using a single protective put, the zero cost collar is a multi-leg strategy that requires a better understanding of options contracts and their dynamics.
Market Impact of Hedging: While not a direct criticism of the zero cost collar itself, widespread use of similar hedging strategies (like portfolio insurance in the 1980s) has been cited as potentially exacerbating market declines, though this is a broader market dynamic rather than a direct risk to the individual collar holder.¹, ², ³, ⁴

Zero Cost Collar vs. Protective Put

The zero cost collar and a protective put are both hedging strategies used to protect a long stock position, but they differ significantly in cost and upside potential.

A protective put involves buying a put option on shares already owned. Its primary benefit is providing downside protection, setting a floor below which the value of the stock will not fall. The key difference is that the investor pays the full option premium for the put, incurring an upfront cost. In return for this cost, the protective put allows the investor to retain unlimited upside potential if the stock price increases.

In contrast, a zero cost collar attempts to eliminate this upfront cost by simultaneously selling an out-of-the-money call option to finance the purchase of the put. While this achieves the "zero cost" (or near-zero) objective, the trade-off is that the investor's upside potential is capped at the strike price of the sold call. The zero cost collar is suitable for investors who are willing to sacrifice some upside in exchange for free or low-cost downside protection, particularly if they anticipate limited capital appreciation or wish to reduce the total cost of their portfolio's risk management.

FAQs

Is a zero cost collar suitable for all investors?

No, a zero cost collar is generally best suited for experienced investors who already hold a significant position in a stock and understand the nuances of options contracts. It requires careful selection of strike prices and expiration dates to achieve the desired risk-reward profile and "zero cost" objective.

What happens if the stock price drops below the put strike price?

If the stock price falls below the put option's strike price, the put becomes "in the money." The investor can exercise the put, selling their shares at the put's strike price, thereby limiting their maximum loss to the difference between their initial purchase price (or the price when the collar was initiated) and the put strike, plus any net premium paid (or minus any net credit received). The maximum loss occurs at the put's strike price.

Can a zero cost collar be adjusted?

Yes, a zero cost collar can be adjusted before its expiration date. Investors can choose to "roll" the collar by closing the existing options and opening new ones with different strike prices or expiration dates. This might be done to capture more upside, lower the protective floor, or extend the duration of the hedge, often in response to changes in the underlying stock's price or market sentiment (e.g., entering a bear market or anticipating a bull market). However, each adjustment will incur new transaction costs and potentially alter the "zero cost" nature of the original strategy.