Costless Collar (Zero-Cost Collar)

The costless collar, or zero-cost collar,  is established by buying a protective put while writing an out-of-the-money covered call with a strike price at which the premium received is equal to the premium of the protective put purchased.

Costless Collar Construction
Long 100 Shares
Sell 1 OTM LEAPS Call
Buy 1 ATM LEAPS Put

Costless collars can be established to fully protect existing long stock positions with little or no cost since the premium paid for the protective puts is offset by the premiums received for writing the covered calls.

Depending on the volatility of the underlying, the call strike can range from 30% to 70% out of money, enabling the writer of the call to still enjoy a limited profit should the stock price head north. This strategy is typically executed using LEAPS® options as the striking price of the call sold can be rather high in relation to the price of the underlying stock.

Costless Collar Payoff Diagram
Graph showing the expected profit or loss for the costless collar option strategy in relation to the market price of the underlying security on option expiration date.

Limited Profit Potential

Profit is limited by the sale of the LEAPS® call. Maximum profit is attained when the price of the underlying asset rallies above or equal to the strike price of the short call.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call - Purchase Price of Underlying - Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Example

Suppose the stock XYZ is currently trading at $50 in June '06. An options trader holding on to 100 shares of XYZ wishes to protect his shares should the stock price take a dive. At the same time, he wants to hang on to the shares as he feels that they will appreciate in the next 6 to 12 months. He setups a costless collar by writing a one year JUL '07 60 LEAPS call for $5 while simultaneously using the proceeds from the call sale to buy a one year JUL '07 50 LEAPS put for $5.

If the stock price rally to $70 at expiration date, his maximum profit is capped as he is obliged to sell his shares at the strike price of $60. At 100 shares, his profit is $1000.

On the other hand, should the stock price plunge to $40 instead, his loss is zero since the protective put allows him to still sell his shares at $50.

However, should the stock price remain unchanged at $50, while his net loss is still zero, he would have 'lost' one year's worth of premiums of $500 that would have been collected if not for the protective put purchase.

Note: While we have covered the use of this strategy with reference to stock options, the costless collar is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Summary

By setting up the costless collar, a long term stockholder forgoes any profit should the stock price appreciates beyond the striking price of the call written. In return, however, maximum downside protection is assured. As such, it is a good options strategy to use especially for retirement accounts where capital preservation is paramount.

Many senior executives at publicly traded companies who have large positions in their company's stock utilize costless collars as a way to protect their personal wealth. By using the zero-cost collar strategy, an executive can insure the value of his/her stock for years without having to pay high premiums for the insurance of the put.

Similar Strategies

The following strategies are similar to the costless collar in that they are also bullish strategies that have limited profit potential and limited risk.

The Collar Strategy
Bull Put Spread
Bull Call Spread

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