What is a Zero Cost Collar?
A zero cost collar is a short-term option trading strategy that offsets the volatility risk by purchasing a cap and a floor for the price of a derivative.
How Does a Zero Cost Collar Work?
A zero cost collar strategy would combine the purchase of a put option (i.e. the ability to sell the option at the capped strike price) and the sale of a call option (i.e. the ability to buy the option), although at a slightly lower floor price). Because the put and call options are based on the same underlying asset, the zero cost collar puts a ceiling or a cap on the sale of the call option if the price falls and offsets the cost of the put option.
For example, if the investor is buying a derivative based on a particularly volatile short term commodity, such as the spot market price for oil, the option premium earned by the sale of the put option at the lower strike price (floor) will provide the funds for the purchase of the call option at the higher strike price (capped price). Because of the relationship between the strike price and the option premium (the lower the strike price, the higher the premium and vice a versa), the earnings from the sale of the put option will fund the call option, but not give a substantial upside.
Once the spot market price exceeds the call option cap (i.e. the strike price), the zero cost collar effectively pays for itself. At that point, the put option will be worthless and will not be needed any more. Alternatively, if the spot market price drops below the put option floor (i.e. the strike price), with the zero cost collar in place, the investor will not be able to participate in the down side.
Why Does a Zero Cost Collar Matter?
By creating a hedge against even moderate swings in a particular commodity, a zero cost collar effectively limits the upside earnings and downside risk.