Key Takeaways
- Hedges downside by buying put, selling call.
- No upfront cost; premiums offset exactly.
- Limits both losses and gains within strikes.
What is Zero Cost Collar?
A zero cost collar is an options trading strategy designed to protect your long position in an underlying asset by simultaneously buying a put option and selling a call option with premiums that offset each other, resulting in no net upfront cost. This creates a price range where downside losses are limited, but upside gains are capped.
This strategy is particularly useful for investors seeking downside protection without paying an option premium, effectively hedging risk while maintaining their position in the asset.
Key Characteristics
Zero cost collars have distinct features that balance protection and cost efficiency:
- Cost-neutral: Buying an out-of-the-money put and selling an out-of-the-money call option generates premiums that equalize, eliminating upfront expenses.
- Limited risk and reward: Losses are capped below the put strike, and gains are capped above the call strike.
- Based on ownership: Requires holding or planning to hold the underlying asset to implement the hedge effectively.
- Customizable strikes: Strike prices and expiration dates can be adjusted to suit your risk tolerance and market outlook.
- Reduces emotional bias: Predetermined boundaries help maintain disciplined trading decisions.
How It Works
The zero cost collar strategy involves three core components: owning the underlying asset, purchasing a put option to set a downside floor, and selling a call option to fund the put with premium income. Selecting appropriate strike prices and expirations is essential to balance premiums and maintain zero net cost.
Typically, the put option is set slightly below the current asset price to protect against significant drops, while the call option is set above to cap potential gains. This creates a "collar" around the asset price, preserving value within a defined range and limiting tail risk exposure.
Examples and Use Cases
This strategy is widely applied across different asset classes and sectors to manage risk efficiently:
- Exchange-Traded Funds (ETFs): Investors often use zero cost collars on ETFs like SPY, setting asymmetric strikes to balance protection and potential gains.
- Cryptocurrency: In volatile markets, zero cost collars can protect holdings; for instance, some choose this approach in managing risk within best crypto investments.
- Stock holdings: Companies such as Delta have used option collars to hedge exposure during uncertain market conditions.
Important Considerations
While zero cost collars offer valuable protection, you should be aware of their limitations. The capped upside means you may miss out on gains if the asset price rises above the call strike. Additionally, although the strategy is termed "zero cost," the opportunity cost of limiting gains is a real expense.
Implementing this strategy requires careful monitoring and understanding of option assignments and expiration risks, especially when dealing with naked options sold as part of the collar. Always consider your investment goals and risk tolerance before applying this hedge.
Final Words
A zero-cost collar effectively limits downside risk while capping upside potential, making it ideal for investors seeking protection without upfront costs. Review your portfolio and option pricing carefully to tailor strike prices that align with your risk tolerance and market outlook.
Frequently Asked Questions
A Zero Cost Collar is an options strategy that protects your long position by buying an out-of-the-money put and selling an out-of-the-money call, with premiums offsetting each other so there's no net upfront cost.
It limits your downside risk by allowing you to sell the asset at the put option's strike price if the price falls, while capping your upside gains if the asset price rises above the call option's strike price.
This strategy is designed for investors who own or plan to own the underlying asset, as it involves hedging that existing long position.
Usually, the put strike is set at or slightly below the current asset price, while the call strike is higher, often farther out-of-the-money to balance the premiums and create the zero-cost feature.
Both options expire worthless, and you keep your underlying asset without any additional gains or losses from the options.
Your maximum loss is limited to the difference between your purchase price and the put strike price, while your maximum gain is capped at the difference between the call strike price and your purchase price.
Because the premium you pay for buying the put option is exactly offset by the premium you receive from selling the call option, resulting in no net upfront cost to establish the position.
It works well in bullish or neutral markets where you want to protect against downside risk while still participating in moderate upside gains, as the call strike is typically farther out-of-the-money to balance premiums.
