Costless Collar (Zero-Cost Collar) Explained

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A trader’s guide to the zero-cost collar options strategy

We look at zero-cost collars and how traders can utilise them in their trading.

What is a zero-cost collar strategy?

A zero-cost collar is an options collar strategy that is designed to protect a trader’s potential downside. It does this by utilising call and put options which, in effect, cancel each other out.

While it will put a cap on potential losses arising from the trade, it will also cap potential profits. It is designed to hedge against volatility in the underlying price of the asset.

When to use the zero-cost collar strategy

The strategy involves the purchase of a put option and the use of an out-of-the-money covered call. The strike price of the call means that the premium received is equal to premium of the purchased put.

A collar is used to protect existing long positions with relatively low cost, as the premium paid for the put is offset by the premium received on the covered calls.

Zero-cost collar strategy example

The pay-off for a zero-cost collar is seen below:

If stock ABC is trading at £10, an options trader with 100 shares of the firm is looking to protect his holding if the price of the shares begins to fall. However, he wishes to hold on to the shares as he expects further gains in the year to come. The trader creates a zero-cost collar by writing a one year £12 call for £1 while also using the proceeds from the sale of the call to buy a one year £10 put for £1.

If the shares rise to around £14, then the maximum profit is limited since the trader is obliged to sell the shares at the strike price of £12. With 100 shares, the profit made on the trade is £200. If the shares fall to £8, then the loss is zero since the put will allow the trader to sell his shares at the £10 specified in the put option.

Disadvantages of zero-cost collar strategy

While the transaction itself is cashless, it does involve an opportunity cost of forgoing investment gains. Investors also face the problem of determining how long to leave the collar in place, which entails the use of market timing. Choosing the wrong length of time could mean giving up future profits, or suffering a loss in the end anyway.

Given that stock markets tend to rise in the long-term, and investors and traders are poor at judging market direction in the near term, many investors would be best served by avoiding complex strategies. But for those experienced at options trading a collar strategy may prove fruitful.

The collar strategy costless collar zero cost collar

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Zero cost collar

Zero Cost Collar is a paper hedge agreement designed to keep your fuel prices within an agreed price range. Also known as cap and floor.

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Here’s an example of how it works

To begin, you and Global agree upon:

  • the monthly volume
  • an appropriate fuel price index (Platts/Argus)
  • a hedging period (e.g. 3 months)
  • a Cap Price (e.g. 100 per tonne)
  • a Floor Price (e.g. 90 per tonne)

Monthly average settles at 110 per metric tonne (10 above the Cap Price. Global pays you 10 per tonne in cash, compensating you for the increase in spot prices.

Monthly average settles at 95 per metric tonne – i.e. between the Cap and Floor Prices. There is no settlement, and you will be exposed to the changes in spot prices within this range.

Monthly average settles at 95 per metric tonne (5 below the Cap Price). You pay Global 5 per tonne in cash, which counterbalances the lower spot prices.

Protection against increasing prices, yet benefit from some decline in fuel prices until the Floor Price is exceeded.

At the end of each calendar month, the settlement amount is based on the difference between the monthly average of the price index and the Cap or Floor Price.

Three good reasons to use this strategy:

  • Rising fuel prices would seriously undermine your business
  • You would like to benefit from falling prices after having fixed your maximum fuel prices
  • You would rather establish a floor level than pay an upfront cap premium

Zero Cost Collar

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Categories: Derivatives, Trading, Stocks

Free 50 Shades gear?

Eh. no. It’s a hedge. of a hedge.

You bought a call option on something reallllly volatile and are nervous about losing everything on that naked call. So you buy a top and a bottom against that call, such that, if theta (time) decays and the call expires worthless, you at least took in some premium along the way; and you trade off upside, such that if the volatile security.com goes nuts on the upside, you are capped. It’s kind of The Nervous Nelly Trade.

Finance: What Is a Put Option? 75 Views

finance a la shmoop what is a put option? hot potato hot potato

ow ow! yeah remember that game well nobody wanted the potato, poor thing. the

players wanted to put it in someone else’s hands. well put options kind [glue put around a flaming potato]

of work the same way. a put option is the right or option or choice to sell a

stock or a bond at a given price to someone by a certain end date.

all right example time. you bought netflix stock at the IPO a zillion years

ago at $1 a share. that’s you know splits adjusted. all right now it’s a hundred

bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in

California that would be a tax of something like almost 40 bucks. well the

stock was a hundred but you keep only something like 60. feels totally unfair.

right so you really don’t want to sell your stock but you’re nervous about the [graph shown]

next few months that Netflix will crater for a while and go down ten

maybe twenty dollars. longer term though you think it’ll hit 300. so this is the

perfect setup to maybe look at buying some put options on Netflix. if the stock

goes down your put options go up. with Netflix volatile but at a hundred bucks

a share ,you look up the price of an $80 strike price put option expiring in

December, and you know that’s mid-september now .for five bucks a share

you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]

term life insurance. you pay the five dollars a share in the stock goes down

to 82 by mid December, worst of all worlds. well not only did you lose the $5

a share but your stock has lost $18 in value. but had Netflix really cratered

and gone to say $60 a share well you would have exercised your put and sold

your shares at 80 bucks. well those put options you paid $5 for

would be been worth 15 bucks a share. in buying that put option you’ve [equation shown]

guaranteed that your loss will be no more than a $75 value for your Netflix

position at least for that time period and ignoring taxes. well remember that

options expire after December whatever like the third Friday of the month it’s

usually when options expire, you then have no protection and your shares float

along naked. naked? really who knew accounting could get so [paper put option goes “skinny dipping”.]

raunchy. yeah well that’s naked put options.

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