What is a Costless Collar (Zero Cost Collar)?
A costless collar, also known as a zero cost collar, is an options spread strategy which aims to minimize losses in long term positions, at little to no cost, as the name suggests.
This is done through selling covered calls in order to receive premiums which will cover any costs associated with the puts that are bought to protect the position. In other words, it is a way to hedge against volatility.
It is important to note that the costless collar works best when Long-Term Equity Anticipation Securities (LEAPS) are used. These are options with more than one year until the expiration date. The reason for this is the fact that time decay can be avoided almost entirely, adding stability to any purchase or sale of options.
How to Enter a Costless Collar
The options collar works relatively well for most assets that have an option available. But since no strategy is the best move in all cases, it is best to fully understand the way that the strategy works so that you can determine if it should be used on a case by case basis.
In order to do that, let's look at an example:
Let's say that stock X is trading at $100. You want to hold onto the shares that you are holding for a long time, so you purchase an option with more than a year before expiration to avoid volatility. You sell the call (bearish trade) in order to hedge, for a premium of $5, with a strike price of $120.
Now that you have the $5, you use that same money to buy a put (also a bearish trade) with an expiration date of more than a year and a strike price of $100
Costless Collar Results
There are a few results that can occur with a costless collar. The first, is that the price of the stock rises to above the strike price of the call that you sold. In this case, any profits that you made would be limited further, because you would be liable to sell your shares for the agreed upon strike price which, in this case, is $110.
Another possibility is that the price drops below the strike price, in which case the purchased put with the strike price of $100 would allow you to minimize your losses, because you would be able to sell your shares for the agreed upon strike price of the put.
For any values between the two, the net profit would be that of the movement of the stock overall, because you will not be required to fulfill the requirements of your call, and the pure agreement would fall through as well, however the premiums of those two would cancel one another out.
In this way, one could also identify a loss as, if only the premium for the sale of the call was collected and not counteracted by the cost of entering the put, there would have been the additional profit of the premium.
However, for the sake of simplicity, this has not been mapped on the graph below, illustrating the possible profit and loss in the event of a costless collar.
Here we can clearly see the maximum profit and loss. This allows a certain hedge against risk but it is important to note that the decreased risk does come at some cost.
Fortunately, due to the use of LEAP options, if the direction of market movement is not favorable, one has the luxury of being able to wait out the situation knowing that you cannot possibly lose any money, and then exit the options once the situation has become more favorable.
Costless Collar Advantages
There is a maximum loss put in place. This allows for easy risk management, as well as hedging against volatility.
Additionally, as mentioned above, the use of LEAP options gives you the luxury of waiting the situation out, even if the market value of the stock continues to decrease. In many well established companies, this is often the case, but may not be worth the risk in other situations.
There are no additional costs to you. This means that it should be accessible to most traders, and allows you to continue trading elsewhere, rather than using all your money to hedge a single position.
Costless Collar Disadvantages
The biggest disadvantage of the costless collar is the fact that profits are severely limited due to the sale of the call. This means that, if the price of the asset that you are trying to hedge increases beyond a certain point, you will be unable to get these profits, and will have to exit the options trade.
It can be very difficult to predict how high an asset is going to go in a set amount of time and in order to achieve the sale of the call, the strike price will need to be set at a relatively possible amount.
Additionally, as mentioned above, if the market value does not drop and you find that you did not make use of the put option, then the loss of the call option premium can also be seen as a loss of sorts.
Is the Costless Collar for You
The key to becoming a successful trader is risk management. If you are new to trading long term positions, or you know that you want to exit a given position in a set period of time, then the costless collar is definitely for you as it will allow you to determine your maximum risk. Even though profit is also maximized, this can be seen as a worthwhile tradeoff.
If, however, you know that what you have invested in is likely to grow after a dip in price, and you are willing to wait as long as it might take for that to happen, then you need to consider if this potential decrease in profit is really worth the maximum risk. This will depend on the nature of what you have invested in more than anything else.
Remember, the key to being a successful trader is to manage your risk, in order to trade responsibly.