What Is a Zero Cost Collar?
Let me explain what a zero cost collar is—it's an options strategy I use to hedge against big swings in an asset's price. You sell a short call and buy a long put, which limits your losses but also puts a cap on your gains. If you've got a long-term stock position that's racked up solid gains, this is a straightforward way to protect those profits.
Key Takeaways
You can limit potential losses with this strategy by buying an out-of-the-money put and selling an out-of-the-money call. It's built to hedge against price volatility, but remember, it also restricts how much you can earn on the upside. Matching the premiums for the put and call isn't always easy, so you might end up with a net credit or debit. This approach safeguards big gains in your long stock positions, though it does limit further upside. And even though it's called 'zero cost,' don't forget about trading fees that can impact your net results.
How the Zero Cost Collar Strategy Works
Here's how it operates: you spend money on one part of the strategy, and that gets offset by income from the other part. I implement this as a protective measure after my long stock position has seen major gains. You start with stock you own, buy a protective put, and sell a covered call. People also call this zero cost options, equity risk reversals, or hedge wrappers.
To set it up, you buy an out-of-the-money put option, which means the seller has to buy the underlying at the strike if exercised, and at the same time, you sell an out-of-the-money call option, where you hope the buyer exercises to purchase at the strike. Both options share the same expiration date.
Take this example: suppose you bought a stock at $100, and a month later it's at $120. To lock in gains, you buy a put with a $115 strike for $0.95 and sell a call with a $124 strike for $0.95. That put costs $95 per contract (0.95 x 100 shares), and the call gives you a $95 credit—net zero cost. You've secured your profits this way.
In terms of outcomes, if the share price ends at $110, your put gives a $5 profit per share after the $120 current price and $115 strike, while the call expires worthless for a $14 potential if exercised at $124, but overall, it's about balancing the protection.
Practical Application of the Zero Cost Collar Strategy
Putting this into practice isn't always straightforward because put and call premiums don't always line up perfectly. You have to decide how close to zero cost you're willing to get. By picking puts and calls with varying out-of-the-money levels, you might create a net credit or debit.
Options farther out-of-the-money have lower premiums, so for a minimal cost collar, choose a call farther out than the put—like a $125 strike in my example instead of $124. For a small credit, do the reverse: a put at $114 while keeping the call at $124.
Keep in mind, a net debit reduces your overall profit, but a net credit boosts it. At expiration, your max loss is the difference between your purchase price and the lower strike, no matter how far the stock drops. Max gain is to the higher strike, even if the stock soars. If it closes between strikes, options expire worthless, and your stock position stays as is.
Is a Costless Collar Really Costless?
The buying and selling of the options themselves make the collar costless in theory, but you should account for additional fees and costs tied to the trade.
What Is the Benefit of a Zero Cost Collar?
The main benefit is minimizing losses if the market turns against you, though selling the call caps your gains— that's the top price you'll get unless the buyer doesn't exercise.
What Is the Risk Reversal?
Risk reversal is essentially the same as a zero cost collar: you sell a call and buy a put on your long position to cut down on the risk of big losses.
Final Thoughts on Zero Cost Collar Strategy
In summary, the zero cost collar lets you hedge major losses by buying a put and selling a call at different strikes, setting bounds on both losses and profits. It's great for protecting gains in a long stock position, but it does limit upside if the price climbs. While useful in volatile markets, matching premiums might not yield exact zero cost. You could explore related strategies like the fence, which uses three options for more risk management options.
Note that this is for informational purposes only—always check warranties and disclaimers for full details. And just to correct any confusion: you buy a put and sell a call for this strategy, not the other way around.
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