Assume you’re holding 100 shares of a stock, and believe it could trade a bit higher over the next six months, but you want to protect your downside in case it doesn’t. A costless collar option strategy allows you to do this. While the strategy won’t require additional cash, it isn’t “free” -there’s a trade off, as your profit potential is also capped.
Understand the costless collar thoroughly, and run the numbers before attempting to implement it so you can see if it’s worthwhile. Here’s how to do it, and what to consider.
The Costless (Zero-Cost) Collar
The costless collar is an options strategy designed to give you bit of extra profit potential, while also capping downside risk. This is accomplished by buying a put option with a strike price at or below the current price of your stock holding, as well as selling (writing) a call option with a strike price above the current stock price.
The put is a cash outlay, as you must pay the premium. The put option caps your downside at whatever the strike price of the put option is.
To cover the cost of the put, sell a call option. For this you will receive a premium. The call option caps your upside on the stock position to the level of the call strike price.
The strategy can be utilized on short-term positions as well as long-term positions. Longer-term traders use LEAPS (Long Term Equity Anticipation Security), which are simply options that can be purchased for distant dates in the future.
Be sure to also read Options 101: American vs. European vs. Exotic.
When to Use a Costless Collar
The strategy is best utilized in a stock that has some upside potential, but the short-term outlook is uncertain. For instance, the price is in an uptrend, but is consolidating (see Figure 2). The price could drop in the short-term, but based on the uptrend you believe you can squeeze a bit more profit when the price starts moving higher again. If it doesn’t move higher, before the expiry of the option, the strategy protects you from further losses below the strike price of the put option.
The options cap risk and profit for a period of time. This is different than a stop loss or profit target order placed directly on the stock position. These orders also limit risk and profit, but once the price touches either of these levels the trade is closed. Not so with options; the stock position remains protected, and potentially able to profit, until either the options are closed out or they expire.
Implementing the Costless Collar
Here’s a real world example using 100 shares of AAPL, which is currently trading at $100.24, and the option premiums in Figure 1 are based on that.
These are LEAPS available on the CBOE at the time of the potential trade. First, decide when you want the options to expire – assume we decide April 2015.
Then, to make the strategy costless, go through the available puts and calls and find strike prices that give you some upside, protect your downside and are very similarly priced.
See also the Protective Put Options Strategy Explained.
In this case, we can buy an April 2015 94.29 put for $4.90 (current ask price), costing a total of $490 ($4.90 × 100 shares). We also sell an April 2015 105 call option for $4.95 (current bid price), receiving a total of $495. Since a put and call will rarely be the exact same price, as in theoretical examples, the costless collar strategy may result in a small debit or credit from the trading account. In this case, you make $5 by implementing this options strategy (not including commissions).
Both the put and call have the same expiry (April 2015), which is 6 months away from the current date (October 2014).
Your downside and upside are now capped. Participate in a price rise up to $105, or $4.76 above the current $100.24 price, and eliminate downside below $94.29, or $5.95 below the current price.
Get option premium prices for any stock (if available) on the CBOE Options Table page. Input a stock symbol, and select “List all options, Leaps…” if you wish to see options that expire more than several months out.
Costless Collar Considerations
You may face some issues implementing a real-world costless options strategy. It’s rare to find a costless collar that gives significant upside potential while keeping your downside very low. In order for the strategy to be costless, you may only get an extra 5% of upside for example, while risking 7% to 10% (varies) on the downside. In the example above our upside potential was 4.74% ($4.76/$100.24), while the downside was 5.93% ($5.95/$100.24).
A costless collar is also typically aimed at investors, because a short term trader is more likely to just sell the stock if unsure of the position. Therefore, the investor is buying an option that expires several months or more into the future. Unless the stock is very well known and heavily traded, there may not be volume in options several months out. If no one else is trading LEAPS in the stock, it isn’t possible to construct a costless collar.
Be sure to also see the 25 Stocks Day Traders Love.
Use the strategy if you want to exit the stock position eventually, but want to try to make a bit more money in the mean time. If you don’t want to lose your equity position, don’t use this strategy
Compute what your upside and downside would be if you executed a costless collar based on current option premiums. Only make the trade if you are comfortable with capping your upside and risk (and the strike prices you can do this at) and potentially being forced to exit the position if the options are exercised.
The Bottom Line
By buying a put with a strike below the current price, and selling a call above the current price, you create a costless collar options strategy. It caps your risk and profit on a stock holding, so it’s best suited to investors who eventually want to exit a position anyway but want to see if they can get a bit more out of it first. In the real-world, put and call options usually won’t have the same price. This means there may be a small cost or profit made when creating the “costless” collar.