Introduction
A costless collar is effectively a trade where the shorted call’s premium is equal to the premium paid on the long put while owning the underlying security. Hence, the cost to construct it is basically free when you exclude ownership of the underlying security. Traditional collar strategies however require some capital outlay.
In a costless collar, even if the underlying security heads south, the trader does not lose any money. If the underlying security increases in price, the trader can experience limited profit.
Therein lies the tradeoff, that profit is capped for a costless collar.
Cost considerations to create a costless collar
While creating the costless collar, the cost of the put should be equal and offset by premium collected from the short call position.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook and market opportunity: Moderately Bullish
Step 3 : Study the option chain
Step 4: Understand Your Profit Zones
Step 5 : Calculate The Maximum risk and loss
Step 6 : Calculate Maximum potential profit
Step 7 : Calculate Risk & Reward Ratio
Step 8 : Set Up Trade : Creating a costless collar
Step 9 : Exit Trade
Step 10 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Identify a candidate for a costless collar by conducting some research on the economy and the underlying security. An options trader can perform some fundamental analysis on the underlying security. Technically and fundamentally, perhaps a trader may see a 5% to 10% rise in the price of the underlying security in a certain time frame. Some suggested chart patterns that traders should look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook and market opportunity: Moderately Bullish
The rationale for establishing a costless collar is to protect the stock holdings from a significant decline in prices and still partake in a slight to moderate increase in the stock price if any. At this point, an options trader should be convinced that there is a potential for a small profit.
Step 3 :Study the option chain
To create a costless collar, the put premium must be equal to the call premium. Hence, the options trader should scrutinize the option chain to find option contracts which can be used to create the zero-cost collar.
Read : Learn to read and understand options chain
Step 4: Understand Your Profit Zones
The payoff diagram above will tell you your profit zones. Understand your profit zones and make sure that there is a high chance that the underlying security will trade at a price within your profit zone.
Step 5 : Calculate The Maximum risk and loss
The costless collar has zero risk. However, if a net credit or net debit results from the establishment of the collar, the formulas below should be used.
If a net debit results, the maximum risk and loss can be calculated as:
Initial share price – put exercise price + net debit
If a net credit results, the maximum risk and loss can be calculated as:
Initial share price – put exercise price – net credit
Step 6 : Calculate Maximum potential profit
The maximum profit can be calculated as:
Call exercise price – initial share price
If brokerage fees are to be considered, the maximum profit is:
Call exercise price – initial share price – brokerage fees
The maximum profit is realisable when the price of the underlying security is greater or equal to the short call exercise price.
Step 7 : Calculate Risk & Reward Ratio
Calculate the risk and reward ratio of the trade. Does this trade have a favorable risk and reward ratio compared to the previous collars you have executed. If you have another strategy that you could use, which strategy has a better risk and reward ratio?
Read : Understanding Risk/Reward Ratio For Option Traders
Step 8 : Set Up Trade : Creating a costless collar
A costless collar can be created by buying the underlying or already owning the underlying security and buying at ATM or OTM LEAPS put and selling an OTM LEAPS call.Doing so would be equivalent to combining a covered call and a protective put. For that reason, traders consider collars as a low or no risk strategy with a possibility of a return on investment in the long term.
Step 9 : Exit Trade
The options trader can exit the costless collar when his target price is reached and the maximum profit has been earned. Assignment is also a possibility that the trader has to face.
Step 10 : Record Trade In Diary
After the trade has been exited, the trader should record his trade in a diary. Analyse what made the trade profitable and if steps can be performed to increased the percentage profit of the trade.
Example of a costless collar
XYZ trades at a price of $30 in 2016. A trader acquires 100 shares of XYZ. He wants to protect the stock holding from a steep decline in its price. However, he feels that in the long term, there is a chance of moderate appreciation in the price of the XYZ.
He longs a 2017 Jan LEAPS put with an expiration date that is 1 year into the future at a strike price of $30. The cost of the put is $6. He also shorts a Jan Leaps call with a strike price of $35 at a price of $6. As a result, the collar was costless.
If the price of XYZ remains at $30 in a year’s time, there is no loss to the trade as he can sell the shares away for $30, the price at which he acquired the shares before.
If the price of XYZ becomes $35 in a year’s time, the shares will be called away leaving the trader with a profit of $500.
If the price of XYZ decreases, there is no loss as the trader can sell away the shares at $30.
Collar Vs Covered calls
A collar is a modified form of a covered call.
Read:
General Overview Of Covered Calls
Execute an In the money covered call
Writing Out-Of-The-Money covered calls
Read also : Execute A Collar Strategy To Limit Downside