What Is a Zero Cost Collar?
A zero cost collar (also known as a costless collar or zero-premium collar) is an options trading strategy designed to protect an investor’s stock position from significant losses while limiting potential gains. It combines:
- A protective put — to limit downside risk
- A covered call — to offset the cost of the put
The goal is for the premium received from selling the call to equal the premium paid for buying the put—resulting in no net cost.
Key Components of a Zero Cost Collar
- Owning the Underlying Stock: The investor holds shares of the stock they want to protect.
- Buying a Put Option: Grants the right to sell the stock at a set strike price, acting as insurance.
- Selling a Call Option: Obligates selling the stock at a set price if exercised, funding the put.
How Does a Zero Cost Collar Work?
The strategy sets a floor (put strike price) and a ceiling (call strike price) on price movement. The put limits losses, while the call caps gains. Because the premiums offset, the strategy costs nothing upfront.
Advantages
- Cost-effective hedging
- Downside protection
- Customizable strike prices
- Retains stock ownership
Disadvantages
- Capped upside potential
- Requires understanding options
- Potential obligation to sell
Practical Uses
- Protecting long-term holdings
- Hedging in volatile markets
- Managing concentrated positions
- Post-earnings protection
- Tax deferral strategy
Example: Step-by-Step
Scenario: You own 100 shares of XYZ at $100 each.
- Buy a Put
- Strike Price: $95
- Expiration: 3 months
- Premium: $3
- Sell a Call
- Strike Price: $110
- Expiration: 3 months
- Premium: $3
The premiums cancel—zero cost. Let’s explore the outcomes:
- If stock falls to $80:
You sell at $95 using the put. Loss capped. - If stock rises to $120:
The call is exercised. You sell at $110. Gain capped. - If stock stays at $100:
Both options expire worthless. You retain shares.
Trading Insights
- Strike Prices: Balance between protection and upside.
- Implied Volatility: Higher IV can benefit premium collection.
- Timing: Best used before anticipated volatility or risk.
- Taxes: Understand implications if shares are called away.
- Rolling the Collar: Adjust if stock moves significantly.
Common Mistakes
- Tight Strike Ranges: Can overly restrict natural movement.
- Ignoring Fees: Commissions and roll costs reduce returns.
- Wrong Timing: Avoid collars in strong bull markets.
- Expiration Risk: Monitor your options' lifespan closely.
Zero Cost Collar vs. Other Strategies
- Protective Put: Requires upfront premium but allows full upside.
- Covered Call: Provides income, but no downside protection.
- Cash-Secured Put: Good for generating income when buying stocks cheaper.
Conclusion
The zero cost collar is a practical options strategy for protecting investments while avoiding upfront costs. It’s ideal for managing risk during uncertain times without sacrificing stock ownership. By understanding the mechanics and aligning the setup with your goals, you can confidently add this to your trading toolkit.