In the world of options trading, the term “zero-cost collar” often suggests a strategy that offers downside protection without any costs to the investor. However, while the strategy may not require an upfront payment, it is not without an implicit cost… specifically, opportunity cost.
What Is a Zero-Cost Collar?
A zero-cost collar is an options strategy designed to protect gains in a stock position. It involves two simultaneous actions:
Buying a protective put option: This gives the investor the right to sell the stock at a predetermined price, thus limiting potential losses.
Selling a covered call option: This obligates the investor to sell the stock at a predetermined price if the option is exercised, thereby capping potential gains.
The premiums from selling the call option offset the premiums required to purchase the put option, resulting in a net-zero cost for the strategy.
How It Compares: Stock Only, Covered Calls, and Puts Alone
To understand the opportunity cost more clearly, it helps to compare a costless collar to a few common alternatives:
1. Stock Only: This approach offers unlimited upside and full downside exposure. It’s the most aggressive path and carries the most risk, but also the most reward in strong markets. There are no option premiums involved.
2. Covered Call: Selling a covered call generates income through premiums but limits upside beyond the strike price. There is no downside protection, so the investor is still fully exposed to losses if the stock declines. This strategy may outperform in flat or modestly rising markets but can underperform in sharp moves in either direction.
3. Protective Put Only: Buying a put offers downside protection but requires an upfront premium, which acts like an insurance cost. Unlike the collar, it leaves upside fully intact. This is a more flexible but more expensive way to hedge, and the cost can be a drag on returns if the protection goes unused.
4. Costless Collar: Combines the protection of a put and the income from a call to offset costs. It offers downside protection and reduces risk, but caps the upside. This is a balanced, conservative strategy, but can be frustrating in strong up markets due to its return ceiling.
The Opportunity Cost: Capped Upside Potential
While the zero-cost collar provides downside protection, it also limits the upside potential. If the stock’s price rises significantly, the gains are capped at the strike price of the sold call option. This means the investor forgoes any additional profits beyond this point.
For example, if an investor holds shares of the SPDR S&P 500 ETF Trust (SPY) and implements a zero-cost collar with a call option strike price slightly above the current market price, any substantial increase in SPY’s value beyond that strike price would not benefit the investor.
Real-World Implications
Implementing a zero-cost collar can be particularly impactful during strong bull markets. Investors may find themselves protected against losses but also excluded from significant gains. This trade-off is the essence of the opportunity cost associated with the strategy. Moreover, adjusting or unwinding a collar position can be complex and may incur additional transaction costs, further affecting the overall return.
When to Consider a Zero-Cost Collar
Despite its limitations, a zero-cost collar can be appropriate in certain scenarios:
- Market Uncertainty: When the market outlook is uncertain and the investor seeks to protect gains without incurring additional costs.
- Specific Financial Goals: When an investor has a target price range for a stock and is comfortable with limited gains in exchange for downside protection.
- Tax Considerations: To defer capital gains taxes by avoiding the sale of appreciated securities while still managing risk.
There Must Be a Better Way
While zero-cost collars serve a purpose, they’re inherently static. The rigid nature of selling a call and buying a put at fixed levels to pay for one another means you’re locking in a narrow path forward, protected on the downside but capped on the upside. In today’s fast-moving and often volatile markets, that can feel like wearing both a seatbelt and handcuffs.
More flexible, active approaches to hedge equity may reduce that opportunity cost. Instead of mechanically selling upside, these strategies adapt to market conditions, adjusting hedge levels or exposure dynamically. This flexibility allows for the possibility of capturing more upside in favorable markets while still offering some downside defense when needed.
Active management doesn’t mean reckless or overly complex. It simply means being responsive. By taking advantage of market dislocations, volatility pricing, and valuation shifts, a more adaptive strategy can potentially offer a better risk-reward balance over time. Investors don’t need to settle for full protection at the cost of full participation.
Conclusion
The zero-cost collar is a valuable tool for risk management, offering a way to protect against losses without an upfront cost. However, investors must be mindful of the opportunity cost, the potential gains they might forgo. For those seeking protection with greater participation, more active and flexible approaches may offer a better path forward. As with any investment strategy, it’s crucial to align the approach with your financial goals, market outlook, and tolerance for risk.
Disclosures
Past performance is not indicative of future results. This material is not financial or tax advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed and all calculations may change due to changes in facts and circumstances.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2505-27.
