Definition
The owner of the Equity/ stock sells the CALL Options (generally out of money) and buys the PUT (also Out of Money) for the Same Expiration Month. The Premium received for selling the CALL is generally same as the premium paid for buying the PUT and the strategy is referred as “Zero Cost Collar”. The Strategy can also be set for a Credit or Debit depending on what the trader’ expectation of the trade.
When to run the strategy
The Stock has shown a lot of upward movement and the trader is still expecting it to go up further. But since it has had a lot of upward movement, he also wants to protect his investment from the downward movement.
The owner of the Stock is expecting the Stock to go up slightly in the short term but not a lot of upward movement. The strategy is generally played for the short term and not for LEAPS.
Benefits of strategy
· You own the underlying stock and don’t require to sell it till called for.
· If the stock price falls down, the loss is limited since you have bought the PUTS and can sell the Stock at Strike Price of PUTS.
Transactions
· You buy the Equity at Price (E) (say $100).
· You sell the CALL (generally Out of the Money) at the Strike Price (S) (say $110) and receive the premium (P) (say $7).
· You buy the PUT (generally Out of the Money) at the Strike Price (S) (say $90by paying the premium (P) (say $7).
Max Profit
Max profit is capped at
CALL Strike Price – Stock Purchase Price - Premium Paid for PUT + Premium Received for the CALL
Example:
Stock Purchase Price: $100
CALL Strike Price: $110
Premium Paid for buying PUT: $7
Premium Received for selling CALL: $7
So Max Profit = $110 - $100 + $7 -$7 = $10
Potential and Max Loss
Potential Loss is
Potential Loss occurs if the Stock Price falls below the Purchase Price.
Example,
Stock Purchase Price $100
Stock Price at Expiration (say): $95
Premium Paid for buying PUT: $7
Premium Received for selling CALL: $7
So Potential Loss= ($95 - $100) - $7 +$7 = $5
Max Loss occurs when the stock value is reduced to PUT Strike Price.
Max loss = Stock Purchase price – PUT Strike Price.
In the above example it will be $90 - $100 = -$10
Breakeven point
In the Zero Cost Collar, the breakeven point is at the Stock Purchase price since the premium paid for PUT is equal to the Premium received for selling the CALL.
Example:
Stock Purchase Price: $100
Premium Paid for buying PUT: $7
Premium Received for selling CALL: $7
So Stock price at breakeven point should be ($100) -$7 +$7 = $100
At Expiration
Ø If the Stock price is above CALL Strike price:
The Stock is called i.e., Stock is removed from your portfolio and the amount equal to Strike price is credited in your account. In this case you have made a profit equal to CALL Strike Price – Stock Purchase Price.
Ø If the Stock price is below PUT Strike price:
Your stock is sold at the PUT Strike Price. In this case you have made a loss equal to PUT Strike Price – Stock Purchase Price.
Ø If the Stock price is between the PUT and CALL Strike prices:
Both the CALL and PUT Options end worthless. You keep owning the stock. If the Stock price is above the stock purchase price, you have theoretically made a profit and if it is below the purchase price, you have theoretically made a loss though you have no obligation to see the stock.
Who should trade this?
Since this strategy has low risk, it can be traded by people at all level
Beginners - Yes
Intermediates - Yes
Experts - Yes
Masters - Yes
Time decay
Ø Time Decay doesn’t affect you much since you have both bought and sold Options.
Ø As Expiration date approaches, the time value of Option will reduce.
Ø The time value reduces to 0 on the day of Expiration.
Points to consider
Ø Brokerage Cost: Always consider brokerage cost when making a trade. Sometimes the significant part of the premium received is used in Brokerage.
