Zero Cost Collars

One of the most clever devices available for locking in a profit on an investment that has appreciated dramatically is known as a zero cost collar. The practice involves three positions.

The first position

First, an attractive position that investors sometimes experience is owning a stock that has appreciated significantly from its purchase price. At certain times investors may feel compelled to make a choice between selling that position and continuing to hold it. Various conflicting factors encourage different actions. If the investor is concerned about the potential for a dramatic price fall in that security, immediately selling it makes sense. If the investor has expectations of further prices advances for that security, holding onto the position makes sense. If the investor would like to sell the security but is concerned about the tax implication, there may be an incentive to continue holding the position. For example, if the security's price appreciation has been rapid the investor's tax obligation could be at the higher short-term capital gains rate. The investor may prefer to wait until the position qualifies for long-term capital gains treatment. Waiting could introduce the risk of a price drop before the long-term requirements are met. Thus, the investor might lose some or all of the capital gains due to waiting. Another constraint that might limit an investor's ability to sell such an appreciate position could be the role the investor has with the company. Perhaps the investor is a major stock holder, a manager, or perhaps even the founder of a company. Such situations might discourage an outright sale. Given these kinds of constraints investors sometimes find themselves in a position that could benefit from a zero cost collar. Consider next the second required position.

The second position

Given the above situation the investor needs to establish protection from a price fall in the appreciated security. A simple way to protect from a price fall in a security is to purchase a put option on that security. Typically, the exercise price on such puts would be set at a level below the existing market price. The lower the exercise price on the put the less expensive it will be to purchase. Of course the lower the exercise price is the more the investor will lose before the put becomes effective. The difference between the market price of the security and the exercise price of the put can be viewed as a cost that is quite similar to the deductible amount on an insurance policy. The deductible amount effectively is the fraction of a loss that is born by the insured party. As in setting insurance premiums larger deductibles produce lower contract costs for puts.

The third position

Finally we can consider the element from which this strategy derives its name. The third position involves a position that generates income. Specifically, a call option is sold on the appreciated security. The money realized from selling the call is used to purchase the put. For the package to work effectively, the call premium needs to approximate the put premium. Clearly to realize equivalent premiums on the put and call the exercise prices of the two options need to be carefully selected. Both the put and the call are typically out-of-the-money. The further out of the money each option is, the lower its premium will be. However, the further out-of-the-money these options are, the wider the spread between their exercise prices. That typically translates into a greater effective "deductible" for the zero cost collar. Thus, wider spreads imply less protection. Of course the wider spread also allows for additional upside potential.

Considerations for matching the second and third positions

The zero cost collar effectively brackets the existing, appreciated price of a security. The range for the bracket can be relatively narrow or it can be wide.