# Understanding Zero Cost Collar: Options Strategy Explained

> **Definition**
>
> A zero cost collar is an options strategy used to lock in a gain by buying an out-of-the-money (OTM) put and selling a same-priced OTM call.

## What Is a Zero Cost Collar?

A Zero Cost Collar is an options strategy tailored to hedge against significant price volatility of an underlying asset. It involves selling a short call and buying a long put to limit losses while capping potential gains. This strategy is ideal for investors seeking to protect profits from long-term stock positions that have experienced substantial gains.  

### Key Takeaways

*   A zero cost collar helps investors limit potential losses by buying an out-of-the-money put and selling an out-of-the-money call.
*   The strategy is designed to hedge against volatility in asset prices, but it also caps potential earnings.
*   Matching premiums for the put and call can be challenging, often resulting in a net credit or debit.
*   This strategy offers protection for significant gains in long stock positions but limits upside potential.
*   Despite being termed "costless," the strategy may incur trading fees that affect net gains.

## How the Zero Cost Collar Strategy Works

A zero cost collar strategy involves the outlay of money on one half of the strategy, which offsets the cost incurred by the other half. It is a protective options strategy implemented after your [long position](https://www.investopedia.com/terms/l/long.asp) in a stock experiences substantial gains.

To create this position, you use stock you own, buy a [protective put](https://www.investopedia.com/terms/p/protective-put.asp), and sell a [covered call](https://www.investopedia.com/terms/c/coveredcall.asp). Other names for this strategy include zero cost options, equity risk reversals, and hedge wrappers.

![Image](https://www.investopedia.com/thmb/1QAiyR9cGl9MQCdBWli31lez46A=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/dotdash_Final_Zero_Cost_Collar_Apr_2020-01-3f7ffff9ccd84d9e8f93fa3cd72c8d4f.jpg)

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To implement a zero cost collar, you buy an [out-of-the-money](https://www.investopedia.com/terms/o/outofthemoney.asp) put option (making the seller buy the underlying at strike) and simultaneously sell an out-of-the-money call option (hoping the buyer purchases the underlying at strike) with the same [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp).

To implement a zero cost collar, buy an [out-of-the-money](https://www.investopedia.com/terms/o/outofthemoney.asp) put option, prompting the seller to buy the underlying asset at the strike price, and simultaneously sell an out-of-the-money call option, anticipating the buyer will purchase the underlying asset at the strike price, both with the same [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp).

For example, imagine you purchased a stock for $100. One month later, it was trading at $120 per share. You want to lock in some gains, so you buy a put option with a $115 [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) at $0.95 and sell a call with a $124 strike price for $0.95. In terms of dollars, the put will cost $0.95 x 100 shares per contract = $95.00. The call will create a credit of $0.95 x 100 shares per contract—the same $95.00. Therefore, the net cost of this trade is zero, and you've locked in profits.

## Practical Application of the Zero Cost Collar Strategy

Executing this strategy may not always be possible because the [premiums](https://www.investopedia.com/terms/p/premium.asp), or prices, of puts and calls don't always match. Investors can decide how close to a zero net cost they want to achieve. Selecting puts and calls with different out-of-the-money amounts can lead to a net credit or debit in the account.

The more out-of-the-money the option is, the lower its premium will be. Therefore, to create a collar with only a minimal cost, you can choose a call option farther out of the money than the respective put option. In the previous example, that could be a strike price of $125.

To create a collar with a small credit to the account, you do the opposite—choose a put option farther out of the money than the respective call. In the example, that could be a strike price of $114.

> **Fast Fact**
>
> A net cost or debit from the collar would reduce the overall profit. Conversely, a net credit from the collar would increase the total profit.

At option expiration, the maximum loss is the difference between your purchase price and the stock's value at the lower strike price, regardless of a sharp stock price drop. The maximum gain is the difference between the purchase price and the stock's value at the higher strike price, even if the stock jumps sharply. If the stock closes within the strike prices, the options expire, leaving the stock’s value unaffected for you.

## Is a Costless Collar Really Costless?

Buying and selling the option make the collar costless, although additional fees and costs might be associated with the trade.

## What Is the Benefit of a Zero Cost Collar?

This strategy minimizes your losses if the market takes a turn for the worse. However, your gains are also minimized by selling the call. That will be the highest price you can get for your stock unless the buyer elects not to exercise.

## What Is the Risk Reversal?

Risk reversal is the same strategy as a zero cost collar. You sell a call and buy a put on a long position to minimize the risk of significant losses.

## Final Thoughts on Zero Cost Collar Strategy

The zero cost collar strategy allows investors to hedge against significant losses by buying a put option and selling a call option at different strike prices, essentially setting limits on both potential losses and profits. This strategy is highly beneficial for those wanting to protect gains from a long stock position, though it does cap potential upside if the stock price rises.

While securing positions in volatile markets, investors should note that matching option premiums might not always result in a zero-cost setup. Other strategies like the ‘fence,’ which involves three options, can also add to one’s risk management toolkit.

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_**Correction—May 20, 2023:**_ A previous version of this article mistakenly stated that a trader needed to buy a call and put option to create a zero cost collar. This was inaccurate, as a trader buys a call and sells a put to create the collar.