Zero Cost Collar: Definition and Example

What Is a Zero Cost Collar?

A zero cost collar is a form of options collar strategy that limits your losses. To execute it, you sell a short call option and buy a long put option whose prices cancel each other out. The downside of this strategy is that profits are capped if the underlying asset's price increases.

Understanding Zero Cost Collar

A zero cost collar strategy involves the outlay of money on one half of the strategy, which offsets the cost incurred by the other half. It is a protective options strategy implemented after your long position in a stock experiences substantial gains.

To create the position, you use a stock you own, buy a protective put, and sell a covered call. Other names for this strategy include zero cost options, equity risk reversals, and hedge wrappers.

To implement a zero cost collar, you buy an out-of-the-money put option (making the seller buy the underlying at strike) and simultaneously sell an out-of-the-money call option (hoping the buyer purchases the underlying at strike) with the same expiration date.

For example, imagine you purchased a stock for $100. One month later, it was trading at $120 per share. You want to lock in some gains, so you buy a put option with a $115 strike price at $0.95 and sell a call with a $124 strike price for $0.95. In terms of dollars, the put will cost $0.95 x 100 shares per contract = $95.00. The call will create a credit of $0.95 x 100 shares per contract—the same $95.00. Therefore, the net cost of this trade is zero, and you've locked in profits.

Using the Zero Cost Collar

Executing this strategy is not always possible as the premiums—or prices—of the puts and calls do not always match exactly. Therefore, investors can decide how close to a net cost of zero they want to get. Choosing puts and calls that are out of the money by different amounts can result in a net credit or debit to the account.

The further out-of-the-money the option, the lower its premium. Therefore, to create a collar with only a minimal cost, you can choose a call option farther out of the money than the respective put option. In the previous example, that could be a strike price of $125.

To create a collar with a small credit to the account, you do the opposite—choose a put option farther out of the money than the respective call. In the example, that could be a strike price of $114.

At the expiration of the options, the maximum loss would be the difference between your purchase price and the value of the stock at the lower strike price, even if the underlying stock price fell sharply. The maximum gain would be the difference between the purchase price and the value of the stock at the higher strike, even if the underlying stock moved up sharply. If the stock closed within the strike prices, then there would be no effect on its value to you because the options would expire.

The Bottom Line

The zero cost collar is a long position strategy that protects you from significant losses if the market drops. To create the collar, you buy a put with a lower strike price and sell a call with a higher strike price. This creates a safety net for you but also limits how much you can make on the underlying asset if the call purchaser exercises. There are other strategies that traders use to manage risk reversal. The fence is one of these strategies and uses three option contracts instead of the collar's two.

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Correction—May 20, 2023: A previous version of this article mistakenly stated that a trader needed to buy a call and put option to create a zero cost collar. This was inaccurate, as a trader buys a call and sells a put to create the collar.