Zero Cost Collar Definition
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.
A Little More on Zero-Cost Collars
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.
References Zero-Cost Collar Options Strategy
Academic Research on Zero-Cost Collar Options Strategy
- · A zero–cost collar option applied to materials procurement contracts to reduce price fluctuation risks in construction, Yim, H. L., Lee, S. H., Yoo, S. K., & Kim, J. J. (2011). International Journal of Social, Behavioral, Educational, Economic, Business and Industrial Engineering, 5(12), 1769-1774. This paper suggests the procurement of materials that explain the contacts model to which the zero cost collar option is employed for the examining of price fluctuation risk in construction. The suggestion of the material contract model is based on the collar option that is majorly made up of the call option striking zone of the buyer (the construction company) provided an increase in the material price cause a decrease in the put option striking zone of the material supplier.
- · Commodity hedging through the zero-cost collar and its financial impact, Kaur, A., & Ratto, A. S. (2016). This research work analyses the impact of finance on the zero-cost collar as well as the commodity hedging through the zero-cost collar.
- · Mitigating wind exposure with zero–cost collar insurance, Fernandes, G., Gomes, L., Vasconcelos, G., & Brandão, L. (2016). Renewable Energy, 99, 336-346. According to this research, acknowledgement from the Renewable energy generation throughout the globe depends mainly on the wind farm. This wind energy is then transformed into electricity. Note that the producers of wind power sign a long-term fixed-price contract in other to hedge against the risk in the price and by so doing, the wind farm is exposed to energy volume risk. In other to alleviate this risk, this paper proposes that wind producers should purchase insurance and develop a stochastic model to determine the feasibility in the range of the wind strike for the insurer and the wind farm.
- · Hedging of Sales by Zero–cost Collar and its Financial Impact, Bartoňová, M. (2012). Journal of Competitiveness. According to the zero-cost option structure that appeared in the ’90s, the combination of the standard has become a popular tool of hedging and also have an exotic option. This research analysis studies the popular zero-collar strategy and according to the research from the sales hedging point of view, the proposition of an application of the strategy in hedging against the drop in the exchange rate of the currency in the future. The aim of this paper is to certify the theoretical findings in a particular option contract for sales hedging. This paper also examines the offer of product in the zero-cost area and their availability.
- · Commodity hedging through the zero-cost collar and its financial impact, Ratto, A. S., & Amandeep, K. (2016). This paper explains the commodity hedging via a zero-cost collar and its financial impact.
- · Managerial ownership, incentive contracting, and the use of zero–cost collars and equity swaps by corporate insiders, Bettis, J. C., Bizjak, J. M., & Lemmon, M. L. (2001). Journal of financial and quantitative analysis, 36(3), 345-370. According to this research thesis, the managerial ownership, use of zero-cost collars, incentive contracting and the equity swaps by corporate insiders were fully analyzed and practically explained.
- · Insider trading in derivative securities: An empirical examination of the use of zero–cost collars and equity swaps by corporate insiders, Bettis, J. C., Lemmon, M., & Bizjak, J. (1999). This research work explains the insider trading in derivative securities by considering an empirical examination of the use of zero-cost collars and equity swaps by corporate insiders.
- · Having Your Options and Eating Them Too: Fences, Zero–Cost Collars and Executive Share Options, Ali, P., & Stapledon, G. P. (2000). Company & Securities Law Journal, 18, 277-282. This paper examines the corporate governance developed from the use by the most executive of fences and the zero-cost collars. These options effectively release the interest of the executive from the shareholders and inversely destroying the economic rationale. This paper also examines how the strategies (fences) and the zero-cost collar can be used by executives to extract values during a vesting period. The Executive Share Option Plan (ESOP) carries out important economic activities by aligning the interest of the company’s executive and the interest of the shareholders.
- · Denomination of currency decisions and zero–cost options collars, Vander Linden, D. (2005). Journal of Multinational Financial Management, 15(1), 85-98. This paper examines the use of the zero-cost currency option collars as a method that can be used to cap increases in the variability of the interest cost. This method was tested using the yen and dollar as examples, the burrowing decision was taken in the year 1994 to 2001, this method offers promises for the firm that has lower expected cost by burrowing yen but want to limit the risk added to it. Note that if the exchange rate adopts a random walk, a company might just be able to minimize the expected cost by borrowing from the currency having the lowest nominal interest rate and increase the volatility of the borrowing cost.
- · A zero–cost collar option applied to materials procurement contracts to reduce price fluctuation risks in construction, Yim, H. L., Lee, S. H., Yoo, S. K., & Kim, J. J. (2011). International Journal of Social, Behavioral, Educational, Economic, Business and Industrial Engineering, 5(12), 1769-1774. This paper suggests a material obtaining contracts model to which the zero-cost collar option is used for heading the price fluctuation risk in construction. This paper determines the call option strike price of the construction company by a simple approach. An increase in the price of put option increases, the risk of loss of the construction company also increases as the steel material price decreases. This study explains the transaction cost as it is originated from an option value that is fluctuated with the volatility. When the collar option with zero transaction cost cuts through the connection between the cost saving and volatility and there was a risk of exercising the put option.
- · Charitable contributions, collars and covered calls in wealth preservation, Duff, R. (1997). Journal of Financial Planning, 10(6), 36. This paper explains the charitable contributions, collars and covered calls in wealth preservation.