Zero cost collar

Zero cost collar
Primary topic
Related topics
Methods and techniques

Zero cost collar(also known as a "costless collar" or "cash-settled collar”)[1] is options collar strategy which provides costless protection for stock or index investments. This method is becoming more and more popular because it contributes to decrease low production risk and is attractive for the investors because of being costless.

This cost-efficient strategy may protect stock gains as a result of limiting potential losses. Bullish investors, those who think that the stock will continue to gain value are tailored to the ZCC strategy[2].

It is often possible to implement close to zero cost strategy[3]. If the price of the stock changed, the maximum gain or loss will be closed within the collar. Thus investor reduces risk of losses, but also reduces won't use oppoertunities related to price growth.

Process of cost collar strategy[edit]

The strategy, includes purchase of a put and at the same time sale of a call. It provides to the call buyer the right to buy a given stock at a price which has already been given[4]. Consequently it creates a cap which is above the actual price, while a floor is installed under the current price of the stock to restrict losses.

Subsequently, the put strike or loss limit is usually set as a first and it depends on the risk appetite of the investor. Then the call strike price is set in such a specific way to generate enough to buy the put. As a result of this, the entire transaction is cost-free. This strategy allows to protect the investment while preserving profit potential[5].

Generated returns from the strategy compared to an accurate market index is used to determine the efficient of the collar.

Motivation to use zero cost collars by corporate insiders[edit]

This strategy is very often used as a private bilateral agreement between corporate employees and some counterparties. Those strategy’s proceeds from the sale of the call are used to offset the cost of the put. As a result, the cost of the hedging is eliminated. What is more, the buyer can monetise the position by borrowing shares escrowed with the counterparty.

The use of the strategy by corporate insiders to protect their position in the company is important. There are two main motivations for corporate employees[6]:

  • significant reduce of risk associated with owned positions by relevant managers
  • more profound motivation and involvement of corporate insiders in a firm

Benefits of using strategy[edit]

The main advantage of a zero cost collar strategy is that it protects the company with no upfront outlay of cash[7]. But there are many more, presented in details[8]:

  • The total cost of the strategy is the same as the allocated assets in portfolio
  • There are no additional investments while using zero cost collar strategy, because the cost of the put is offset by the sell of the call
  • Investor is protected by the zero cost collar from significant deterioration in the value of the investment
  • The strategy protects investor even when the stock index fell 50%, the loss would be maximum 10%
  • The return to the investor is equal to the return which is provided by index
  • Investor knows what will be the potential return that zero cost collar will provide

Footnotes[edit]

  1. Bettis, J. C., (2001), Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders, The Journal of Financial and Quantitative Analysis
  2. Basson, L.J., (2018), Performance of two zero-cost derivative strategies under different market conditions, "Cogent Economics & Finance"
  3. Bettis, J. C., (2001), Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders, The Journal of Financial and Quantitative Analysis
  4. Basson, L.J., (2018), Performance of two zero-cost derivative strategies under different market conditions, "Cogent Economics & Finance"
  5. Basson, L.J., (2018), Performance of two zero-cost derivative strategies under different market conditions, "Cogent Economics & Finance"
  6. Bettis, J. C., (2001), Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders, The Journal of Financial and Quantitative Analysis
  7. Fernandes, G., (2016), Mitigating wind exposure with zero-cost collar insurance, "Renewable Energy"
  8. D’Antonio, L., (2009), Exploring the Use of Equity Collars in Asset Allocation: A Simulation Approach, “Journal of Financial Service Professionals”

References[edit]

  • Basson, L.J., (2018), Performance of two zero-cost derivative strategies under different market conditions, "Cogent Economics & Finance", No. 6: 1492893.
  • Bettis, J. C., Lemmon, M., & Bizjak, J. (2001). Insider trading in derivative securities: An empirical examination of the use of zero-cost collars and equity swaps by corporate insiders, "The Journal of Financial and Quantitative Analysis", Vol. 36, No. 3.
  • D’Antonio, L., & Johnsen, T., (2009). Exploring the Use of Equity Collars in Asset Allocation: A Simulation Approach, “Journal of Financial Service Professionals”, November No. 1, 43.
  • Fernandes, G., Gomes, L., Vasconcelos, G., Brandao, L., (2016), [1],Mitigating wind exposure with zero-cost collar insurance, "Renewable Energy", Vol. 99, 336-346.
  • Kolb R.W., Overdahl J.A., (2003). Financial derivatives,[2] John Viley & Sons, New Jersey, 134.

Author: Rafał Gamrat