Is the Zero-Cost Collar an Effective Hedging Strategy?

The zero-cost collar strategy is an options trading strategy that involves the simultaneous purchase of a put option and the sale of a call option. The options are usually of the same maturity, and the transaction results in a zero or small credit to the trader’s account.

This strategy is often used by investors who are bullish on a stock but want to protect themselves against a potential drop in the price. By buying the put option, they have the right to sell the stock at a predetermined price (the strike price). If the stock price falls below the strike price, they can sell the stock and offset any losses.

The sale of the call option helps to offset the cost of the put option and results in a zero or small credit to the trader’s account. This strategy is sometimes referred to as a “zero cost” collar because the net cost of the trade is zero.

Reference [1] examined the effectiveness of the zero-cost collar strategy in the developed and developing markets. It pointed out,

It was observed that the developing economies relatively outperformed the developed economies. The developed economies, however, showed resilient performance over the full period with consistent growth and less volatile movements. It was also observed that moderate levels of market volatility combined with high-performing indices provide the scenario for the zero-cost collar to result in respectable returns. Furthermore, in order to add to this performance the levels of Kp or strike level of the put option contract needs to be increased. Consequently, respectable results will be produced during periods of both significant market downturns and when the market is trending, trading and decreasing in value. Therefore, the contribution of this paper was to provide investors with a trading strategy to effectively manage turbulent market conditions (such as during the Covid-19 pandemic) by implementing a strategy that has a continuous approach of implementation.

From the figures in the article, we observed that the zero-cost collar strategy usually underperformed the market indices. Therefore we’re not sure if it added any value.

Let us know what you have observed.

References

[1] Lj Basson, Suné Ferreira-Schenk and Zandri Dickason-Koekemoer, The performance of zero-cost option derivative strategies during turbulent market conditions in developing and developed countries, Cogent Economics & Finance, Volume 10, 2022 – Issue 1

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