Zero cost collar

Zero cost collar
See also
Long Hedge Interest Rate Collar Fair value hedge Trading capital Options Swap Ratio Contingent consideration Short Call Trading Book

Zero cost collar(also known as a "costless collar" or "cash-settled collar”) 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.

It is often possible to implement close to zero cost strategy. 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

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. 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.

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

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:

• 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

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

• 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

Examples of Zero cost collar

• An investor owns 100 shares of XYZ company and wants to limit their maximum risk associated with their investment. They could purchase a put option with a strike price of $95 and sell a call option with a strike price of $105. The net cost of the collar would be zero, as the premiums received for selling the call option would be equal to the cost of the put option. This type of collar strategy would protect the investor from any downside losses if the stock price drops below $95, while also limiting their upside gains to $105.
• An investor owns 500 shares of ABC company and wants to protect themselves from any sharp declines in the stock price. They could purchase a put option with a strike price of $50 and sell a call option with a strike price of $70. The premiums received from selling the call option would offset the cost of the put option, making the net cost of the collar zero. This approach would protect the investor from any losses if the stock price drops below $50, while also capping their upside potential at $70.
• An investor owns 1,000 shares of DEF company and wants to ensure that their investment does not suffer any losses. They could purchase a put option with a strike price of $30 and sell a call option with a strike price of $50. The premiums received from selling the call option would equal the cost of the put option, making the net cost of the collar zero. This type of strategy would protect the investor from any losses if the stock price drops below $30, while also limiting their upside potential to $50.

Limitations of Zero cost collar

• Zero cost collar does not eliminate the underlying risk of the asset. It simply shifts the risk from the investor to the option writer.
• It is not suitable for investments with a very volatile price. If the price of the asset fluctuates too much, the collar might not provide any protection at all.
• It is not suitable for short-term investments. Since the expiration dates of the options used in this strategy are usually long-term, the investor has to wait a long time to gain any profit.
• The investor should have a good understanding of options and be able to identify an appropriate strike price.
• The investor should have sufficient capital to cover the cost of the options sold.

Other approaches related to Zero cost collar

• Protective Put: A protective put is an options strategy that is used to limit the downside risk of an underlying stock or index. It involves buying a put option on an underlying stock or index with the same expiration date as the stock or index investment.
• Covered Call: A covered call is an options strategy that involves holding a long position in an underlying stock or index and simultaneously selling a call option on the same stock or index. This strategy is used to generate income by collecting premiums from the call option while still being able to benefit from any potential upside in the stock or index.
• Collar Spread: A collar spread is an options strategy that involves holding a long position in an underlying stock or index and simultaneously selling a call option and buying a put option on the same stock or index. This strategy is used to limit the downside risk while still being able to benefit from any potential upside in the stock or index.

In summary, these strategies are all commonly used to limit the downside risk of an underlying stock or index investment, with Zero cost collar being the most cost effective of all.

References

• 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 Wiley & Sons, New Jersey, 134.

Author: Rafał Gamrat