What is a Zero Cost Collar?
A Zero-Cost Collar, also known as a zero-cost option, equity risk reversal, or hedge wrapper, is an option strategy where an investor holding shares of a particular stock simultaneously buys an out-of-the-money put option (an option to make someone purchase the shares at a price well below the current value) and sells an out-of-the-money call option (an option to purchase the stock at a price well above the current value) for the same price. The transaction to results in zero net costs for the transaction as the purchase of the put option is offset by the sale of the call option. The purpose of this strategy is to lock in the maximum potential gain and maximum potential loss on holding the stock. The stock is only used to reduce risk when an investor takes a long position on a stock (buys stock with the intention of holding for a long period) that has previously experienced substantial gains. Also, it must be that case that she can buy and sell options at the same price.
How Does a Zero-Cost Collar Work?
The zero-cost collar is primarily employed during bear markets (markets that are declining). This is because the primary purpose of the strategy is to limit downside risk (risk associated with the price of the subject shares dropping). The put option protects the investor from losing or forfeiting much of the gains the stock has experienced (up to the strike price of the put option) without having to immediately sell the stock. The benefit of this approach is that it allows the investors to defer taxation associated with selling the stock and to capture dividends while holding the stock. Unfortunately, the strategy is difficult to implement, as the cost of a put option rarely matches up perfectly with the price of selling a call option. Investors will generally employ this strategy and attempt to get to as close to breakeven as possible when buying and selling opposing options.
Example of a Zero-Cost Option
Assume that an investor purchases stock at $100 per shares. The stock quickly rises to $120 per share. It is highly possible that the shares will drop in price in the near future. The investor purchase a put option that allows her to force the seller to purchase the shares for $110 if she so chooses. She would only chose to do so if the price of the stock dropped below $110. The cost of buying the option is $1. Next, the investor sells a call option with a strike price of $125. This option allows the purchase to force the investor to sell the stock to her for $125. She will only do this if the price of the stock goes above $125. The investor earns $1 for selling the call option. The cost of the put option is offset by the revenue from selling the call option. The result is a zero-cost position that secures against losses if the stock drops below $110. The downside is that it prevents capitalizing on a situation where the stock rises above $125.