Costless Collar

A Costless Collar (also known as a 'zero-cost collar') is an options strategy used by investors who already own an underlying stock to protect against a significant price decline. It involves simultaneously buying a protective put option and selling a covered call on the same stock. The strategy is designed to be “costless” because the premium received from selling the call option is intended to offset the premium paid for the put option. By establishing a collar, an investor creates a price range—a “collar”—for their stock. This sets a “floor” price below which their losses are minimized and a “ceiling” price above which their potential gains are capped. It's essentially a trade-off: you give up some upside potential in exchange for downside protection, all without paying for that protection out-of-pocket. This technique is a form of hedging and is particularly popular among investors with large, concentrated stock positions, such as corporate executives, who wish to protect unrealized gains without immediately selling their shares and triggering a taxable event.

Imagine you're building a fence to keep your prize-winning sheep (your stock) in a safe pasture. The collar strategy builds this fence for you, with one side protecting from a fall and the other capping the climb. It consists of two simple parts, or “legs.”

First, you buy a protective put option. A put gives you the right, but not the obligation, to sell your stock at a predetermined price (the strike price) before a certain date. This acts as an insurance policy. If the stock's market price plummets, your put option guarantees you can still sell it at the higher, pre-agreed floor price, limiting your potential loss. Of course, like any insurance, this protection comes at a cost—the premium you pay for the option.

So, how do you pay for that insurance? You pay for it by selling a call option. A call gives its buyer the right to purchase your stock at a specific strike price. When you sell this call, you receive a cash premium from the buyer. This creates an obligation for you to sell your shares if the price rises above the call's strike price. Because you already own the stock, this is known as a “covered call.” This call option sets the ceiling for your potential profit. The magic happens when you select the strike prices for the put and the call so that the premium you receive from selling the call is equal (or very close) to the premium you pay for the put. Voilà! You have downside protection at a net cost of zero.

Let's say our investor, Jane, owns 100 shares of TechGiant Inc., currently trading at $150 per share. Her total position is worth $15,000. She's happy with her long-term prospects but is worried about a potential market correction in the next few months.

1. Step 1: Buy the Put. Jane buys one put option contract (for 100 shares) with a strike price of $140, expiring in three months. The cost (premium) for this put is $5 per share, for a total of $500 ($5 x 100 shares). This sets her floor. No matter how low TechGiant stock falls, she can sell her shares for at least $140 each.
2. Step 2: Sell the Call. To fund the put, Jane simultaneously sells one call option contract with a strike price of $165, expiring on the same date. For selling this call, she receives a premium of $5 per share, for a total of $500 ($5 x 100 shares). This sets her ceiling.

The $500 she received from the call perfectly finances the $500 she spent on the put. She has successfully established a costless collar.

• If the price falls to $130: Jane is protected. She can exercise her put and sell her shares for $140, preventing a further $10 per share loss.
• If the price rockets to $180: The buyer of her call will exercise it, and Jane must sell her shares for $165. She misses out on the gains above $165, but she still made a handsome profit.
• If the price stays between $140 and $165: Both options expire worthless. Jane keeps her shares, and the whole strategy cost her nothing. She is free to hold the stock or set up a new collar.

So, is this a smart move for a value investor? The answer is… it depends. On one hand, legendary value investors like Warren Buffett have famously been skeptical of complex derivatives, arguing that if you are truly confident in the long-term value of a business you own, you shouldn't be worrying about short-term price swings. Trying to hedge against volatility can look a lot like trying to time the market, which is a game that value investors typically avoid. Capping your upside also runs counter to the “let your winners run” philosophy. On the other hand, a costless collar can be a highly pragmatic tool for capital preservation in specific situations:

• Tax Management: An investor might be sitting on a massive capital gain in a stock they feel is now fully valued. Selling would trigger a huge tax bill. A collar allows them to protect those gains through a period of uncertainty (like a major economic report) while deferring the sale to a more tax-advantageous time.
• Concentration Risk: An executive whose net worth is almost entirely tied up in company stock is not diversified. Using a collar is a responsible way to manage this extreme risk without having to sell the shares that signal a lack of confidence to the market.

For the value investor, a costless collar should not be a core strategy for generating returns. Instead, view it as a specialized, temporary risk-management tool. It's less about trying to outsmart the market and more about prudently protecting what you've already built, which is a principle any value investor can appreciate.