Zero Cost Collar

Zero Cost Collar

A zero cost collar is an options strategy used to lock in gains on a long stock position while limiting downside risk. It combines buying an out-of-the-money (OTM) protective put with selling an OTM covered call, typically with the same expiration, so the premium paid for the put is offset by the premium received for the call.

Key takeaways

• Protects unrealized gains on a long stock position by setting a floor (put) and a ceiling (call).
• “Zero cost” refers to matching put and call premiums; in practice, net credit or debit and trading costs are common.
• The strategy limits both downside risk and upside potential.
• Also called zero cost options, equity risk reversals, or hedge wrappers.

How it works

1. Hold the underlying stock you want to protect.
2. Buy an OTM put (protective put) to establish a downside strike price.
3. Sell an OTM call (covered call) with the same expiration to collect premium.
4. Choose strike prices so the put premium is approximately equal to the call premium; the result can be a near-zero net premium.

Example:
* Stock purchase price: $100; current market price: $120.
* Buy a put with a $115 strike for $0.95 (cost = $95 per 100-share contract).
* Sell a call with a $124 strike for $0.95 (credit = $95).
* Net cost ≈ $0; you have locked in a range of outcomes between $115 and $124 per share (ignoring fees).

Outcomes at expiration

• If stock ≤ lower strike (put strike): your downside is limited—your effective sale price is the put strike.
• If stock ≥ upper strike (call strike): upside is capped—you may have to sell at the call strike.
• If stock closes between strikes: both options expire worthless and you retain the stock.

Maximum loss and gain (relative to original purchase price):
* Maximum loss = purchase price − lower strike (limited by the put).
* Maximum gain = upper strike − purchase price (capped by the call).

Practical considerations

• Premium matching: It’s often difficult to find puts and calls with identical premiums. Changing strike distances creates a net debit or credit.
• More OTM call than put → net debit (cost).
• More OTM put than call → net credit (adds to profit).
• Trading costs and commissions make the strategy rarely truly “costless.”
• Strike selection determines the trade-off between protection and retained upside.
• Time to expiration influences premium sizes and how long protection lasts.

Benefits and drawbacks

Benefits:
* Locks in gains and limits downside without selling the underlying.
* Flexible: investors can adjust strike selection and expiration to match risk tolerance.

Drawbacks:
* Caps upside potential when stock rallies above the call strike.
* Requires active management if you want to change protection or avoid assignment.
* Not always free — premiums may not match and trading costs apply.

Variations and alternatives

• The “fence” strategy uses three options to shape a different risk/reward profile.
• The term “risk reversal” is sometimes used interchangeably with similar collar-like hedges.

When to use it

A zero cost collar suits investors who want to protect significant unrealized gains on a long stock position for a defined period while remaining exposed to moderate upside within a capped range.

Summary

A zero cost collar is a practical hedging tool that buys a protective put and finances it by selling a covered call. It provides defined downside protection and limits upside potential, with real-world costs and trade-offs driven by premium availability, strike selection, and transaction fees.