Have you ever wanted to hedge your stock position to limit potential losses but didn’t want to shell out money for the privilege? Then the zero cost collar strategy is for you. In this guide, we’ll walk you through how it works, provide an example, share the pros and cons, and give you the tools to set up your own zero cost collar. Read on to learn how to hedge without the headache.
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What Is a Zero Cost Collar?
A zero cost collar is a trading strategy used to lock in profits from an underlying stock while avoiding losses. It establishes a price range for a stock using put and call options with the same expiration date.
To execute a zero cost collar, you buy a long put option below the current stock price and sell a short call option above the current stock price. The proceeds from selling the call option offset the cost of the put option. This creates a “collar” range of prices where you are protected from losses.
A zero cost collar is also called a hedge wrapper because it allows you to lock in the maximum potential profit and maximum potential loss on holding the stock.
Example
As a zero cost collar example, say you bought a stock for $100, and it’s now trading at $120 per share. To secure some profit, you decide to purchase a put option with a $115 strike price for $0.95 and sell a call with a $124 strike price for $0.95. The put option will cost you $95.00 ($0.95 x 100 shares per contract), and the call will generate a credit of $95.00 ($0.95 x 100 shares per contract). As a result, this trade will have a net cost of zero, allowing you to lock in your profits.
This example is well illustrated in the zero cost collar payoff diagram above.
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Understanding Zero Cost Collar
A zero cost collar is an options strategy that allows you to lock in a range for a stock’s price without paying any net premium. It involves buying a protective put option and selling a covered call option.
A zero cost collar strategy requires spending money on one part of the strategy to balance out the expenses of the other part. This options strategy is used to protect against losses after making significant profits from a long position in a stock.
To set up a zero cost collar, buy a put option with a strike price below your stock’s current market price. This put acts as insurance in case the stock price drops. You then sell a call option with a strike price above the current market price. The premium you receive from selling the call offsets the cost of the put, leaving you with a net zero cost.
Within the collar, your stock is protected. If the share price falls below the put’s strike price, the put option allows you to sell at that price. And if the stock climbs above the call’s strike price, the call option means you’ll sell at that higher level. Outside of the collar, though, your profits and losses are uncapped.
Using a Zero Cost Collar
Once you’ve entered a zero cost collar, managing and monitoring your position actively is important. Below you can see some key things to keep in mind.
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- Monitor the underlying stock price
Keep a close eye on how the underlying stock’s price is moving in relation to your collar. If the price approaches the upper strike price, you may consider rolling the collar up to lock in profits. If the price drops near the lower strike, you’ll need to determine if you want to roll down the collar to avoid losses or exit the position.
- Adjust the strikes when needed
Don’t be afraid to adjust the upper and lower strikes to match your risk tolerance and lock in profits or avoid losses. You can roll the strikes up, down, or out to a later expiration.
- Exit when your objectives change
A zero cost collar is a temporary position, so you’ll need to exit at some point. If your investment objectives change, the underlying stock price moves outside your strikes, or time decay significantly impacts your position, it may be time to exit the collar. You can exit by buying back the short call, selling the long put, or letting both options expire.
- Consider your tax liability
While a zero cost collar has no upfront cost, you may face capital profits taxes when you exit the position. The taxes you owe will depend on whether you exit with a profit or loss. Understanding the potential tax impact before entering into a collar is a good idea.
Keeping these tips in mind will help you manage a zero cost collar position effectively and achieve your investment goals. With active monitoring and management, these “zero cost” positions can be fruitful.
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Frequently Asked Questions (FAQs)
The zero cost collar is a popular option strategy, but you probably still have questions about how it works and whether the risks can be calculated. Let’s look at some of the most frequently asked questions about a zero cost collar strategy.
What Is the Maximum Potential Profit?
Since a zero cost collar involves buying a put option and selling a call option with the same expiration date and underlying stock, your maximum profit is capped at the strike price of the call option you sold. If the stock price rises above the call strike, you lose out on any additional profit.
What Is the Maximum Potential Loss?
Your maximum loss is limited to the difference between the put strike price and zero. Since the collar was established for no cost, the most you can lose is the amount the stock falls below the put strike. The put option protects you from any loss beyond that amount.
What Happens At Expiration?
At expiration, a few things could happen:
- The stock price is between the put and call strikes: Both options expire worthless, and you keep the stock.
- The stock price is below the put strike: You exercise the put and sell the stock at the put strike price. Your loss is limited to the put strike minus the stock price.
- The stock price is above the call strike: The call option is exercised, and you sell the stock at the call strike price. Your profit is capped at the call strike price minus the stock price when you entered the collar.
Can I Exit a Zero Cost Collar Early?
Yes, you can exit a zero cost collar anytime before expiration. You would simply buy back the put option you sold and sell the call option you purchased. The prices of the options at the time you exit the trade will determine if you have a profit or loss when closing the collar position.
Is a Costless Collar Really Costless?
The collar strategy for buying and selling options can be costless, but it’s important to note that there may be additional fees and costs involved in the trade.
What Is the Benefit of a Zero Cost Collar?
When the market turns for the worse, this strategy helps minimize your losses. By selling the call, your profit is also minimized. Selling the call sets the highest price you can get for your stock, unless the buyer chooses not to exercise it.
So, a zero cost collar can be a good strategy if you want to hold onto a stock long-term but hedge against short-term price swings.
The Bottom Line
A zero cost collar is a great way for investors to lock in profits or protect an existing stock position at no upfront cost. It does limit your profit if the stock price skyrockets, but for a no-cost strategy, a zero cost collar provides an attractive risk-reward trade-off for many traders and investors.
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