Risk is a given when trading on or investing in the stock market. Suave investors do not hide from the risk or avoid stock market trading and investment because of it. Instead, they implement risk management strategies and take protective measures.
Surely you would not avoid ever sitting in a car or on a two-wheeler because of the number of road accidents that take place in a year. You would simply wear your seatbelt or a helmet and ensure that the vehicle is functioning properly; probably insist on an attentive driver who does not use his phone in traffic. What you’re doing here is minimising the risk of a road accident.
In the same way, traders have a good choice of options when it comes to minimizing their risk depending on the type of security that they are trading or investing in, the investment term, their earnings targets, risk appetite and so on.
In this blog post, we are going to discuss a risk management strategy employed when investing in futures and options, namely zero-cost collar.
What is a zero-cost collar?
A zero-cost collar is a risk mitigation strategy used in options trading. Its goal is to minimize any losses occurring from the trade and it achieves this by purchasing put and call options that cancel each other out – at least in terms of the premium paid. The zero-cost option strategy is typically used for long term investment in options.
How zero-cost collar works
Imagine that Rahul has 100 shares of an auto accessories company called X Tyres. The shares of X Tyres are currently trading at Rs 650 each.
Rahul being the savvy and experienced trader has forecasted that the share price is going to increase next year on account of an automobile that is expected to hit the roads then, that only uses X Tyres. He wants to hold on to his shares despite the chances that prices might fall in the short term.
Rahul creates a zero-cost collar by writing a one year Rs 720 call option for Rs 100 and simultaneously, Rahul uses that Rs 100 obtained from the sale of the call to buy a one year Rs 650 put option for Rs 100.
When the next year rolls around and the automobile launch (that Rahul is expecting to elevate the share price) finally takes place, two things could happen:
If the share price rises to Rs 750, Rahul has no choice but to sell the shares at Rs 720, as per his call option contract. He earns Rs 720-Rs 650 = Rs 70 per share, multiplied by 100 shares = Rs 7000, in total.
If the share price falls to Rs 620, Rahul still gets to sell shares at Rs 650 as per the put option contract. The loss is zero, thanks to the zero-cost option. The trader fails to earn, but at least his capital is protected.
Benefits of zero-cost option strategy
- Cost is offset
In the example detailed above, you will have noted that both the put and call option was for Rs 100. As a result, the trader or investor does not incur any additional costs while implementing this risk management strategy. Hence the name zero-cost collar.
- Risk is minimised
If the share price falls, instead of rising (as predicted by the trader holding on to shares with the hope of a stock price uptrend), the trader does not have to accept losses and sell his shares for the lower share price. He still gets to sell at the price listed in his put option. In our example about Rahul and X Tyres, Rahul might have lost Rs 3000 if he had to sell at that moment in the absence of the put option.
- Investment is retained
The trader or investor need not hurriedly exit the market as soon as prices begin falling, especially if he predicts a recovery and stock price increase at a later date.
- Peace of mind
At the end of the day, we are all only human and therefore prone to being anxious about our belongings, especially hard-earned capital. Anything that keeps us up at night is going to be eliminated sooner or later. A zero-cost collar allows you peace of mind by giving you some assurance that you will not have to sell at a loss
Considerations when utilising zero-cost option
- Other costs are still incurred
You can still incur brokerage fees and other costs associated with trading. If these charges add up to a sizable chunk it will eat into your capital.
- Earnings are limited
While your losses are limited, your earnings are limited too. Sure, you will not have to sell at a lower price than the current price. However, even if the share price soars, you’ll only get what is specified in your call option contract.
- Possibility of zero earnings
Similarly, although you are protected from potential losses, there is a chance that you will make zero earnings.
You might miss a price rise that happens in the interim.
Zero cost collar could be an amazing risk management strategy once a trader or investor has developed sufficient stock market experience. Calculated stock market predictions represent an art that is perfected with experience. Meanwhile, you can minimise risk by simply setting a stop loss.