• Skip to primary navigation
  • Skip to main content
  • Skip to primary sidebar

Epsilon Options

Options Trading Education

  • Home
  • How Options Work
    • Puts and Calls Explained
    • Learn Options Trading
    • LEAP Options Explained
    • Put Call Parity
    • Buy to Open vs Buy to Close
    • Volatility Skewness | IV Skew In Options
  • Options Greeks
    • Delta
    • Vega
    • Gamma
    • Theta
    • Rho
  • Options Spreads
    • Long Call
    • Bear Put Spread
    • Iron Condor
    • Bull Call Spread
    • Covered Calls
    • Calendar Spread
    • Backspread
    • Strangle
    • Butterfly
    • Protective Put
    • Straddle
  • Options Brokers Reviews
  • Blog
  • Show Search
Hide Search

Zero Cost (Costless) Collar Explained


Table of Contents

  • What Is A Zero Cost Collar?
  • The Costless Collar Explained In Detail
  • Zero Cost Collar Example
  • Pros Of Zero Cost Collars
  • Cons Of Zero Cost Collars
  • Conclusion

What Is A Zero Cost Collar?

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:

Costless Collar Example: Bought Stock
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.

The new P&L is:

zero cost (costless) collar
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.


Further Reading On Options Trading...

Options Trading Strategy: Long Call

A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is delta and theta positive. Introduction Options can provide ...
Read More

Options Theta Explained: Price Sensitivity To Time

Options theta measures option price sensitivity to time. Time Decay & Options Theta All things being equal options lose value over time - so called 'time decay' - and theta ...
Read More

LEAP Options Explained: What Are They And How Do They Work?

Investors that are looking to make longer-term bets may use LEAP Options. Description of LEAP Options A LEAP option is essentially an option with longer terms than standard options. The ...
Read More

The Synthetic Covered Call Options Strategy Explained

What Is A Synthetic Option Strategy? A synthetic covered call is an options position equivalent to the covered call strategy (sold call options over an owned stock). It consists of ...
Read More

In The Money (ITM) Options Explained

In the money options are those whose strike price is less (for call options) or more (for put options) than the current underlying security price. Options provide the right to ...
Read More

Options Rho: Sensitivity To Interest Rates

Rho is the sensitivity of an options's price to changes in interest rates. It is usually only worth considering for long dated options such as LEAPS. Rho is the least ...
Read More

Strangle Spread: A Guide To This Options Trading Strategy

The Strangle Spread Options Trading Strategy Introduction Options, and combination trades such as the strangle spread, can be a very useful tool for both novice and seasoned traders and investors ...
Read More

Options Delta Explained: Sensitivity To Price

Options Delta is the measure of an option’s price sensitivity to the underlying stock or security’s market price. It is the expected change in options price with a 1c change ...
Read More

Buy to Open vs Buy to Close

What is Buy to Open vs Buy to Close? We look at these two similar, but not exactly the same, concepts. There are two ways you can participate in the ...
Read More

Options Spreads: Put & Call Combination Strategies

Options Combinations Explained Options spreads involve the purchase or sale of two or more options covering the same underlying stock or security (ref). These options can be puts or calls ...
Read More

Options Trading Education

Options trading is a potential lucrative sideline for those willing to put in the effort. Epsilon Options is here to help you learn the skills you’ll need to become a ...
Read More

Put Call Parity

Put Call Parity Introduction Options trading can be relatively simple and can also become highly technical. One of the most important basic concepts when it comes to trading options is ...
Read More

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

Would you like to learn stock options trading but don't know where to start? Well we've got your back and designed this step by step guide on how to educate ...
Read More

Options Gamma Explained: Delta Sensitivity To Price

Gamma is the options greek measuring the sensitivity of delta to changes in stock price. Option traders tend to find it relatively easy to understand how the first-order Greek metrics ...
Read More

Options Trading Strategies: Call And Put Backspreads

Backspreads: Extreme Bullish Or Bearish Options Trading Strategies What Are Backspreads? A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that ...
Read More

Primary Sidebar

Featured Posts:

Options Spreads: Put & Call Combination Strategies

Protective Put: This Defensive Put Option Strategy Explained

Options Greeks: Theta, Gamma, Delta, Vega And Rho

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

LEAP Options Explained: What Are They And How Do They Work?

Options Trading Strategy: Butterfly Spread

Copyright © 2021 · Monochrome Pro on Genesis Framework · WordPress · Log in

  • Facebook
  • Twitter
  • Pinterest
  • Privacy Policy