Options Trading Made Easy: Zero-Cost Collar

Options Options Trading
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A zero-cost collar (also called a “costless collar”) is a strategy that uses select calls and puts in order to eliminate the cost of initiating a traditional collar strategy. And because it employs longer-term options (LEAPS) to create the zero-cost aspect of the trade, it has become a widely used and affordable means of wealth insurance for corporate executives whose compensation is based heavily on their company’s shares.zero-cost collar
Let’s look first at the nuts and bolts of the trade before we break down how it’s best employed.

Setting the Trade

The zero-cost collar has three distinct components:

  1. Ownership of 100 shares of the underlying;
  2. The purchase of an at-the-money protective LEAPS put; and
  3. The sale of an out-of-the-money LEAPS call to offset the cost of the put.

As with all collars, the goal is:

  1. To avoid taking a loss on the shares (the at-the-money put takes care of that).
  2. Avoiding paying too much for the protective put (hence the short call).

Of course, the short call limits the trade’s upside, so those who believe there are considerable gains to be had over the long term might want to consider a different strategy – or, alternatively, reset the trade if and when the shares are called away.
Here’s a case study of the proper use of the zero-cost collar using stock of Urban Outfitters (NASDAQ: URBN).
URBN zero-cost collar
It’s early October 2013, and with a sizable position in Urban Outfitters stock purchased at $35, you’re getting nervous. The stock has just tumbled toward your buy price, and you’re loathe to think your gains might soon turn into losses.
You speak to your broker, and he suggests implementing a zero-cost collar as a means of insuring you against any further downside. There’s no cost to the trade, he explains, but your upside will be capped by the short call you’re selling to negate the cost of the insurance.
As the stock touches $35, you decide to go for it (red circle). For every 100 shares of the underlying, you buy an at-the-money put with nearly a year to go before expiry – specifically, the September (2014) 35 strike for $7. And to offset the cost, you sell the September (2014) 39 call for $6.90 (black boxes).
It’s not a perfect zero-sum transaction, but at just $0.10 a pair you deem it well worth the expense.

A Year’s Worth of Ups and Downs

The next 12 months bring a range of prices, from $32.50 to $40.50, and you feel confident knowing you’re protected absolutely on the downside by the puts, as every dollar lost on the shares is a dollar gained on the options.
Conversely, as the price climbs, your gains are capped at the short call strike of $39, meaning any close above that level at expiry will still give you a $4 maximum gain when the shares are called away.
As it turns out, the shares expire at $38.50 (blue circle), both puts and calls expire out of the money, and you pocket $340 ([$38.50 – $35 – $0.10] x 100), or 9.7%, on every board lot traded.
Nice work.

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