A collar is an option combination that involves buying a put option and writing a covered call on a stock or ETF that you own in your portfolio and that you're concerned may decline in the near future. The zero-cost collar is another option strategy.
When the market is looking dicey in the short-term, what do you do with your investment portfolio? Of course, you analyze each individual stock or exchange-traded fund (ETF) and ask whether it should be sold or continue being held.
If the purpose of that stock is income (dividends) and you've held that stock a long time, consider holding onto it, especially if the underlying company is strong (it has stable or growing sales, net income, and so on).
But if you're still worried in spite of all that and you don't want to sell the stock for whatever reason, consider doing a variation of a particular option combination: the collar — namely, the zero-cost collar.
Say that you have 100 shares of XYZ stock (a perennial favorite among stock investing authors!), and it's at $40 per share. You want this protection for the next, say, three months. Here are the components of the zero-cost collar:
Write a covered call option at a strike price of $45 (expiring in three months).
Buy a put option at a strike price of $35 (also expiring in three months).
A zero-cost collar is so named because it pays for itself; there's no out-of-pocket cost for the trade. If you structure the trade right, the money you receive from writing the call pays for the put option you're buying. You've then effectively bought insurance against downside risk, and it didn't cost you anything. Here's what can happen, depending on the stock's movement:
Staying steady: If the stock's price moves sideways and stays lower than $45 and above $35, the options expire worthless in three months. But you don't mind, because you got protection for three months at essentially no cost.
Soaring: If the stock soars to $45 or higher, then you'll be required to sell the stock at $45. But no worries: You're selling the stock at a higher price, so you still realize a nice gain.
Crashing: If the stock crashes to some point below $35, then the collar gives you a double profit that could offset most or possibly all of the stock's downside move. The call loses value, but because you sold it, you don't mind; you keep the premium you received when you wrote the call. This is your first profit. In addition, the put option you bought goes up in value, giving you a gain when you cash out the put. This is your second gain.
The next time the market looks troubling to you, don't panic. You can deploy many great strategies, and one of them is the zero-cost collar.
