May 7, 2024

Zero-Cost Collar: What It Is and How It Works

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Crypto trading often requires risk management strategies that don’t sacrifice potential gains. Enter the zero-cost collar strategy, a tactical approach involving simultaneous execution of two options trades.

A financial collar caps potential profits but offers a balanced compromise, providing downside protection in the notorious crypto market.

In this guide, we’ll discuss the full details of the zero-cost collar options strategy, including how it works, its benefits and limitations, and an example to illustrate the concept.

What is a zero-cost collar in crypto, and how does it work?

A zero-cost collar is a financial strategy used in options trading. It operates on the same principles in cryptocurrency as in traditional financial markets, but it's applied to digital assets like Bitcoin (BTC) and Ethereum (ETH).

In cryptocurrency trading, a zero-cost collar involves:

Buying a put option: This contract gives the holder the right, but not the obligation, to sell a specified amount of a cryptocurrency at a predetermined price (aka strike price) within a set time frame. This put option is a hedge against the decline in the crypto’s price.
Selling a call option: Concurrently, the trader sells a call option on the same cryptocurrency. This call option grants the buyer the right, but not the obligation, to purchase the cryptocurrency at a certain price within a certain period. The premium from selling this call option helps finance the put option’s purchase.

The zero-cost aspect of the collar comes from the arrangement where the income earned from selling the call option offsets the cost of buying the put option. This strategy allows traders to protect their crypto holdings against downside risk without an upfront cost. However, it also limits the upside potential, as any gains beyond the call option’s strike price will accrue to the call’s buyer, not to the cryptocurrency’s holder.

Example of a zero-cost collar strategy

Now that we’ve established the significance of options and puts spread in a collar strategy, let’s take a look at a hypothetical example.

Imagine a trader owns one Bitcoin, which currently trades at $40,000. They’re concerned about potential short-term downside risk due to market volatility, but they also don't want to sell the crypto. To hedge their position without incurring additional costs, they implement a zero-cost collar strategy.

Step 1: Buying a put option

They buy a put option for one BTC with a strike price of $35,000, expiring in three months. This put option will allow them to sell their Bitcoin at $35,000 regardless of how low the market price may fall.
The cost of this put option (aka the premium) is, let's say, $2,000.

Step 2: Selling a call option

To finance the put option’s purchase, they sell a call option on the same one BTC with a strike price of $45,000, also expiring in three months.
By selling this call option, they receive a premium of $2,000, which offsets the cost of buying the put option, making this a zero-cost strategy.

Possible outcomes

Bitcoin’s price falls below $35,000: If BTC drops to $30,000, for example, they can exercise the put option and sell BTC for $35,000, protecting themselves from a further decrease in value.
Bitcoin’s price rises above $45,000: Suppose BTC rises to $50,000. The buyer of the trader’s call option can exercise their right to buy BTC at $45,000. Although the trader will miss out on the extra $5,000 gain, they’ll benefit from the increase from $40,000 to $45,000.
Bitcoin’s price stays between $35,000 and $45,000: If BTC stays within this range until the expiration of the options, both options will expire worthless. The trader would neither make nor lose money from the options, and they still hold their 1 BTC, which is now worth whatever the current market price is.

Overall, the trader will effectively hedge their Bitcoin holding against significant downside risk without incurring upfront costs, but they cap their upside potential. If BTC skyrockets well above $45,000, they’re committed to selling at only $45,000.

Benefits of zero-cost options strategy

The costless collar approach helps manage risk in the unpredictable crypto market. But that’s not all. Here are the key benefits of using a zero-cost option strategy in crypto trading:

No upfront cost

As the name suggests, the zero-cost nature of the strategy means that the premium received from selling the call option offsets the cost of buying the put option. This allows for hedging without additional expenditure.

Hedging against downside risk

Zero-cost collar protects against a decline in the cryptocurrency's value. By buying put options, traders can set a floor on the potential losses they might face if the market moves unfavorably.

Upside potential maintenance

Although the strategy caps the maximum gain (due to the sold call option), it still allows traders to benefit from some upward movements in the market up to the call option's strike price.

Increased flexibility and customization

With a zero-cost collar strategy, traders can tailor the strike prices of the call and put options per their risk tolerance and market expectations. This flexibility is particularly beneficial in the volatile crypto market.

Reduced emotional trading decisions

By establishing a clear strategy with predetermined price levels for potential selling and buying, zero-cost collar helps traders avoid making impulsive decisions based on market fluctuations.

Strategic exit and entry points

The strategy can be used to set strategic exit and entry points for a position in a cryptocurrency, helping traders better plan their trading strategies.

Disadvantages of zero-cost collar strategy

While the zero-cost collar strategy offers several benefits in managing risks, understanding its potential drawbacks is equally important. This strategy can protect against downside risk but comes with certain trade-offs and complexities. Below are the key disadvantages of employing a zero-cost collar strategy in crypto trading:

Capped upside potential

Zero-cost collar limits potential profits. When traders sell a call option, they agree to sell their cryptocurrency at a certain price, meaning if the market price soars above this level, they miss out on these additional gains.

High learning curve

Options trading, by nature, is more complex than just buying and selling assets. It requires a good understanding of how collar options work, which might be challenging for less experienced traders.

Opportunity cost

Zero-cost collar can lead to a scenario where the market doesn't move as expected, and both options expire worthless. In such cases, the opportunity cost of not being able to participate fully in favorable market movements can be a significant drawback.

Adjustment challenges

Adjusting a zero-cost collar in response to market changes can be complex and might incur additional transaction costs, impacting the strategy’s overall effectiveness.

Risk of early assignment

In the case of American-style options, there's always a risk of early assignment with the sold call options, which can disrupt a trader’s strategy.

Dependent on market conditions

A zero-cost collar strategy heavily depends on market conditions. In a less volatile market, the benefits of this strategy might not justify its costs and limitations.

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