Zero Cost Collar

A zero cost collar is a risk management strategy that can be used to protect an investment from downside risk while still allowing for some upside potential. It is a combination of a put option and a call option, and the net cost of the strategy is zero.

The put option gives the investor the right to sell the underlying asset at a specified price, called the strike price. The call option gives the investor the right to buy the underlying asset at a specified price.

The strike price of the put option is typically set below the current market price of the underlying asset, and the strike price of the call option is typically set above the current market price.

The difference between the strike prices of the put and call options is called the collar width. The collar width represents the maximum amount of money that the investor can lose if the underlying asset price falls below the strike price of the put option.

The zero cost collar is a relatively low-cost way to protect an investment from downside risk. However, it does not provide any protection against upside potential. If the underlying asset price rises above the strike price of the call option, the investor will not be able to participate in the gains.

The zero cost collar is often used by investors who are bullish on the underlying asset but are concerned about a potential decline in its price. The collar can help to protect the investor from a sharp decline in the price of the underlying asset, while still allowing for some upside potential.

Here is an example of how a zero cost collar can be used to protect an investment. An investor owns 100 shares of ABC stock, which is currently trading at $50 per share. The investor is concerned about a potential decline in the price of ABC stock, so they decide to enter into a zero cost collar.

The investor buys a put option on ABC stock with a strike price of $45 per share. The put option costs $5 per share, so the total cost of the put option is $500 (100 shares * $5 per share).

The investor also sells a call option on ABC stock with a strike price of $55 per share. The call option generates $5 per share in premium income, so the total premium income is $500 (100 shares * $5 per share).

The net cost of the zero cost collar is $0 ($500 - $500). The collar width is $10 per share ($55 - $45).

If the price of ABC stock falls below $45 per share, the investor will exercise the put option and sell the stock at $45 per share. The investor will lose $5 per share on the put option ($50 - $45), but they will make $5 per share on the call option ($55 - $50). The investor's net loss will be $0.

If the price of ABC stock rises above $55 per share, the investor will let the call option expire worthless. The investor will make $5 per share on the put option ($50 - $45), but they will lose $5 per share on the call option ($55 - $50). The investor's net gain will be $0.

The zero cost collar is a relatively low-cost way to protect an investment from downside risk. However, it does not provide any protection against upside potential. If the underlying asset price rises above the strike price of the call option, the investor will not be able to participate in the gains.