What Is A Zero Cost Collar?
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:
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.
The new P&L is:
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.
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.