Zero Cost (Costless) Collar Explained

What Is a Zero Cost Collar?

A zero cost collar is a sophisticated financial instrument employed by market participants to hedge their investments against potential risks. At the same time, it enables investors to maintain the possibility of earning limited profits. The strategy is also referred to as a zero premium collar or costless collar strategy.

Employing zero premium collar lets investors protect the value of their underlying assets, such as stocks or cryptocurrencies like Bitcoin, without incurring additional costs. This risk management approach is particularly beneficial for those who seek to safeguard their investments in volatile markets.

Key Takeaways

• A zero cost collar strategy provides protection against potential losses while allowing for limited profit potential, making it an attractive strategy for risk-averse investors.
• It is particularly useful in volatile environments like the cryptocurrency markets, where price fluctuations can be substantial and unpredictable.
• The strategy involves simultaneously buying a put and selling a call with the same expiration date, effectively creating a “collar” around the base asset's value.
• Profits are limited, but so are losses, making this an appealing option for risk-averse investors or those who require a more conservative investment approach.
• The zero cost collar strategy requires careful consideration of various factors, including timing, fees, and commissions.

Understanding Zero Cost Collar

To begin with, costless collar strategy is based on the purchase of a put and simultaneous sale of a call. As a reminder, the purchase of a put grants the holder the right to sell the base asset at a predetermined strike price. And the sale of a call makes the seller obliged to purchase the asset at another specified strike price.

Both options should have the same expiry date. The aim is to create a “collar” around the current value of the underlying cryptocurrency. Thereby, we limit the risk of loss caused by price fluctuations while still allowing for potential gains.

Here is the zero cost collar graph where we can see limited losses altogether with limited profit:

By carefully selecting the strike prices for the put and call contracts, the investor can tailor the costless collar strategy to their specific risk tolerance and market outlook. This customization aspect is one of the key advantages of this approach, as it allows investors to adapt the strategy to their individual needs and goals.

Using the Zero Cost Collar

When employing the zero cost collar hedge, an investor buys a put option to protect against potential decreases in the asset's value. Concurrently, they sell a call option to finance the purchase of the pu. Ideally, the premium received from selling the call option will equal the premium paid for the put option, resulting in no additional costs for the investor. This is why it's called a “zero cost” or “costless” collar.

In some cases, the premiums from the put and call options may not perfectly offset each other, leading to a small net cost or a slight net credit for the investor. Nevertheless, the overall cost of the strategy remains relatively low compared to other risk management approaches.

Limited Profit Potential

While the zero cost hedging strategy effectively safeguards the underlying asset's value, it also caps the potential for profit. For instance, if the asset's price rises beyond the strike price of the call, the option will be exercised. In this case, the investor will be obligated to sell the asset at that predetermined price, thus limiting their earnings.

Conversely, if the asset's price falls below the strike price of the put, the investor will exercise the put option. Thus, selling the asset at the higher predetermined price will protect them from further losses.

It is essential for investors to weigh the trade-offs between risk protection and potential profit when implementing the zero cost collar strategy. It is worth noting that the limited profit potential may not be suitable for all investment objectives.

Pros and Cons of Zero Cost Collars

Pros

• Provides protection against potential losses. The primary advantage of the costless collar strategy is that it offers a layer of protection against potential losses, which can be particularly valuable in volatile markets such as the cryptocurrency sector.
• No additional costs or minimal costs. As the sale of the call option ideally funds the purchase of the put contract, the strategy typically incurs no additional costs or only minimal costs, making it an attractive option for cost-conscious investors.
• Customizable. Investors can tailor the zero cost collar strategy to their specific risk tolerance and market outlook by selecting appropriate strike prices for the put and call contracts.
• Can be applied to volatile markets. The strategy is well-suited for volatile markets, such as the cryptocurrency market, where traditional risk management approaches may be less effective.

Cons

• Profit potential is limited. One of the main drawbacks of the zero cost collar strategy is that it caps the potential earnings on the underlying asset. This limited profit potential may not be suitable for market participant who are seeking substantial returns.
• Possibility of no earnings. In a situation where the asset's price remains stable or fluctuates within the range established by the collar, the investor may see no profit or loss. The strategy may effectively result in a “break-even” scenario, which may not be ideal for those seeking to grow their investments.
• Timing is crucial. The success of the costless collar strategy depends heavily on the timing of the options' expiry date. If the options expire too soon or too late, the investor may not receive the desired level of protection or potential gains.
• Additional costs. While the strategy is called a “zero cost” collar, there may still be costs involved. For example, there may appear brokerage fees, commissions, and the bid-ask spread on the options. Market participant must factor these costs into their calculations when determining the overall effectiveness of the strategy.

When to Use the Zero-Cost Collar Strategy

The zero-cost collar strategy is particularly useful in volatile markets, such as the cryptocurrency market. Investors who are concerned about potential declines in the value of their Bitcoin holdings, for example, can employ the costless collar to hedge their investments without incurring additional costs. The strategy can also be beneficial for investors who have a short-term outlook on their investment or who wish to lock in gains on an appreciated asset while still participating in potential further appreciation.

Example

Let's consider a more detailed zero cost collar example involving Bitcoin, with a current price of $20,000. An investor who owns 1 Bitcoin is concerned about potential price fluctuations and decides to implement the zero cost collar strategy. They purchase a put option with a strike price of $19,000 and sell a call with a exercise price of $21,000. Both options have the same expiration date — three months in the future.

In this scenario, the investor has established a collar between $19,000 and $21,000. If the price of Bitcoin falls below $19,000, the put option will be exercised, protecting the investor's downside. If the price rises above $21,000, the call option will be exercised, limiting the investor's profit potential to $1,000 per Bitcoin.

Supposing that the price stays between $19,000 and $21,000, neither option is exercised. In this case, the investor retains their Bitcoin, potentially benefiting from any future appreciation.

Commissions

It's essential to remember that implementing the costless collar strategy often involves brokerage fees or commissions. Although the strategy aims to offset the costs of the put option by selling the call contract, these additional fees should be considered when calculating the overall cost and potential returns of the strategy.

Considerations When Utilizing Zero-Cost Option

Other costs are still incurred

Brokerage fees, commissions, and the bid-ask spread on the options are some of the expenses that investors should factor into their calculations when evaluating the overall effectiveness of the strategy.

Earnings Are limited

By selling the call option, investors effectively cap their potential earnings at the exercise price of the call option. This trade-off between risk protection and profit potential should be carefully evaluated to ensure the strategy aligns with the trader's objectives and risk tolerance.

Possibility of Zero Earnings

If the price of the base asset remains stable or fluctuates within the range established by the collar, the investor may experience zero earnings. In such scenarios, the strategy results in a “break-even” outcome, which might not be ideal for investors seeking to grow their investments.

Timing

The success of the zero cost collar strategy is heavily dependent on the timing of the options' expiry date. If the options expire too soon or too late, the investor may not receive the desired level of protection or potential gains. It is essential to carefully choose the expiration date of the options, taking into account market conditions, the investor's risk tolerance, and their outlook on the base asset.

Conclusion

The zero cost collar strategy is an effective risk management tool for investors, particularly in volatile markets like cryptocurrency. While it offers protection against potential losses and requires no additional costs or minimal costs, the strategy also limits profit potential and requires careful consideration of various factors, such as timing, fees, and commissions. By understanding the pros and cons of this approach, investors can make informed decisions about whether the costless collar strategy is suitable for their investment objectives and risk tolerance.

Frequently Asked Questions (FAQs)

Can the Zero-Cost Collar Strategy Be Applied to Cryptocurrency Investments, Such as Bitcoin?

Yes, the zero-cost collar strategy can be applied to cryptocurrency investments like Bitcoin. It can help protect against potential losses in the volatile cryptocurrency market while still allowing for limited profit potential.

How Does the Zero-Cost Collar Strategy Help Manage Risk in a Volatile Market, Such as the Cryptocurrency Market?

The zero-cost collar strategy helps manage risk by creating a “collar” around the current value of the base asset. This is achieved by simultaneously buying a put option and selling a call option, thus limiting the risk of loss due to price fluctuations.

Are There Any Drawbacks to Using the Zero-Cost Collar Strategy in Cryptocurrency Trading?

The primary drawback of using the zero-cost collar strategy in cryptocurrency trading is the limitation on profit potential. Additionally, there is a possibility of no earnings if the asset's price remains stable, and the success of the strategy depends heavily on the timing of the options' expiration date. Furthermore, investors need to consider additional costs, such as brokerage fees and commissions, which may affect the overall cost-effectiveness of the strategy.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.