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What is a Zero Cost Collar Strategy and How to Execute it?

15 Jun 2023

Introduction

There are a lot of techniques and strategies that allow investors to minimize their losses in the market. Risk is something that all investors have to face at one point in time or another. Instead of shying away from the market due to fear of risks, savvy investors implement risk mitigation strategies. A zero-cost collar strategy is an option that does the same. It minimizes the loss an investor would face in case there is a dip in the price of the underlying asset.

How does a zero-cost collar strategy work?

As the name suggests, the actions performed in a zero-cost collar strategy end up taking no cost. This is done by selling a short call option and buying a long put option. The premiums that are paid on the two cancel each other out. Usually, such a strategy is used for long-term investment options.

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What is an example of a zero-cost collar strategy?

This above concept is not very easy to grasp. So, let's try to understand it with the aid of an example.

Let's consider that you own some shares at a company and each share is going for ₹150 at the moment. You are speculating that the share prices are going to be on the rise in the coming year. Hence, even though you are certain that the share prices will fall in the short term, you still want to hold on to your shares to reap profits in the long term. This is where a zero-cost collar strategy helps.

Here, you can decide to write a one-year ₹250 call option for ₹100 and at the same time, use the ₹100 that you acquired from that sale to buy a one-year ₹150 put option for ₹100. When the following year commences, there could be two probable outcomes:

  1. If the price of the share increases to, let us say, ₹300, you will still be forced to sell at ₹250. In this case, you will only earn a profit of ₹100 on each share.
  2. If the price of the shares falls to, let us say, ₹230, you still have the right to sell your shares at ₹150, according to the put option. You don’t really earn any profits, but at the same time, at least, you don’t suffer any losses either.

What are the benefits of a zero-cost collar strategy?

As discussed above, a zero-cost collar strategy, in short, secures the holder and minimizes risks. But now, let us look at some of its benefits in a bit more detail:

  1. Retained investment: The investor is provided with the luxury of time. They don’t need to leave the market as soon as the prices start falling, since they already made a contingency plan.
  2. Mitigation of risks: Risk is mitigated almost completely when taking up a zero-cost collar strategy.
  3. Cost-effectiveness: As is evident from its name, the zero-cost collar strategy is one such security option. It costs the holder, for all intents and purposes, virtually no extra capital or resources.

Closing thoughts

The zero-cost collar strategy is a great method of minimizing risks in a cost-effective manner. While it is relatively light on the wallet of the investor, this strategy does require the investor to have an extremely good grasp of the market. This is because accurate speculation and prediction are a huge part of what makes a zero-cost collar strategy successful.

While the actual cost of buying and selling might be balanced out, the investor might incur other costs in the form of brokerage fees and other charges associated with the trade. Your earnings might be limited or even nil but at the same time, your losses will be nil as well. So, it requires an exceptional understanding of the market environment when engaging in zero-cost collar strategies.

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