Zero cost collar definition
A zero cost collar is a form of collar option strategy where the credit of money on one leg of the strategy offsets the amount debited for the other leg. Options collar is a protective option strategy that is implemented after a long position in an underlying that has experienced substantial gains. The trader buys a put as well as the underlying and sells a call on top of it. The option collar strategy can have a symmetrical pay out diagram. However choosing strikes that give symmetry will usually result in noticeable credit/debit to the traders account. As you can deduce from the above. The zero cost collar is usually asymmetrical. Often with bigger max loss than maximum gain. However sometimes arbitrage may be possible, especially for LEAPS options. Continue reading if you want to learn more about zero cost collar arbitrage.
Zero cost collar example
Imagine we have a long position in XYZ on 1 of February 2019 and the current price is 100$. The underlying just made a sharp move up and we want to secure our profit. We can buy an August 2019 95 put for $3.60 (current ask price). That costs a total of $350 ($3.50 × 100 shares). We also sell an August 2019 105 call option for $3.50 (current bid price). receiving a total of $360. Since a put and call will rarely be the exact same price. As in theoretical examples. The zero cost collar strategy may result in a small debit or credit from the trading account. In this case, we had to pay $10 to enter this options trade (assuming no commissions).
Both the put and call have the same expiry (August 2019), which is 6 months away from the current date (February 2019). Your downside and upside are now capped. Participate in a price rise up to $105, or $5 above the current $100 price, and eliminate downside below $95, or $5 below the current price.
Disadvantages of zero cost collar
The transaction is often cashless. However the opportunity cost of missed gains is sometime s very high.
When you determine how long to leave the zero cost collar in place you timing the market. Which is hard to do.
Option payoff profiles are nonlinear. This means that the range of outcomes can be asymmetric. The zero cost collar usually will have bigger loss potential than maximum gain potential. This is often a disadvantage for the investor.
In general, option strategies are complex. This often makes them expensive to trade for retail traders since huge spreads and transaction costs will compound.
Depending on the term length of the option, any gains may be taxed at your ordinary income rate rather than long-term capital gain rate. The zero cost collar strategy above is beneficial if the market falls sharply. However the marginal benefit decreases as you pay taxes on the gains of the put option.
Zero cost collar arbitrage
Under right circumstances opportunities for zero cost collar arbitrage can arise in various markets. However by far this occurrence is the most popular in LEAPS options markets. Most often the trade won’t be a “pure” arbitrage opportunity. Instead you will see a chance for “statistical arbitrage”. To preform it you must enter a costless collar position in which maximum profit is bigger then maximum loss.
Very rarely you may find opportunities for “pure” arbitrage. In those cases your collar may have no downside at all and you will only be able to profit. However you are not guaranteed to make money so in essence this is still not classical arbitrage. Otherwise it wouldn’t be even possible for retail traders to see those opportunities. The last thing to keep in mind is the cost of capital and associated “opportunity cost”. If your money is frozen in a collar that won’t profit you still have made a loss equal to the risk free interest rate.
Costless collar main problem – timing!
You may think. That a costless collar is a “no-brainer” even if there are no opportunities for arbitrage. You could even think that zero cost collar is great when max loss is slightly bigger then the max profit. After all it’s a small price to pay to reduce your portfolios volatility. Is it not? All you have to do is estimate how much an underlying could possibly rise and you know your strikes! Well… Unfortunately it’s not that simple. The single biggest problem with trading zero cost collars is timing the market! If you chose a wrong expiration you may get stuck in a unwanted trade. You may not be able to realize profits if the underlying starts falling before expiry.
Are we saying that you can’t liquidate your position and get out? Not really. But there is one nasty charcteristic of zero cost collar you need to know. It’s often “inefficient” to exit them prior to expiry! If the underlying goes up you will have to repay a more expensive call and if it falls you will need to get rid of your protection.
Zero cost collar as oil hedge
There is an one market where collar options strategy is particularly popular. The global oil market. Many companies in other industries like to hedge materials costs with swaps or futures. That’s because a precise price of raw materials is essential for their operations. Oil refineries however are very happy to operate in a range of prices. At least as long as it’s not too big and price movements aren’t extremely sharp. Costless collar can help satisfy that need with savings on the cost of futures contango effect. How does it work? Most of the time you will have to enter an asymmetrical zero cost collar. Which has a bigger max loss than max profit. That is the trade off here. You sacrifice “favorable odds” to avoid paying for contango.