Zero-Cost Collar Strategy in India: An In-Depth Guide

The zero-cost collar strategy is a fairly well-known hedge instrument employed in stock markets to avoid fluctuation. It is embraced by those investors who wish to avoid heavy losses in stocks and yet they do not want to pay the normal fees that are associated with putting a place in options. With equity markets undergoing range-bound volatility affecting key stock indexes, zero cost collar strategy is most favorable for investors who are risk averse holding long-term investment portfolios of the Nifty index or large capitalization scripts.

A zero-cost collar is formed from put and call options where an individual buys a put option on stock, and simultaneously, sells a call option on the same stock, preferably of the same expiration date. Of course, this ends up costing far more to purchase than its value, while the sale of the call option makes it the so-called ‘zero-cost’ strategy. It is a structure that also provides the investor with an opportunity of avoiding risks that can be assumed while at the same time, setting a limit on the potential profit.

Illustration of the Zero-Cost Collar Strategy

For instance, an investor with an asset in the Nifty wants to hedge this investment with the help of the zero-cost collar strategy. Present value is at 17,100 and the investor is going to create a zero cost collar with one month to maturity.

Steps in the Strategy

Put Option Purchase: The investor enters into a put option where he gets a right but is obliged to sell the standard portfolio at a specified price; usually, the strike price is below the current Nifty level, say at 16,900. This option helps minimize losses if the Nifty index falls below this level.

Call Option Sale: At the same time, the investor sells a call option at a premium above the current nifty level, say 17300.

Thus the net effect of these two choices form the basic foundation of the zero-cost collar strategy in which the investor gets to control a defined price value across the Nifty or a similar stock portfolio.

Example Calculation:

Option Type	Strike Price	Premium Collected/ Paid
Put (Bought)	16,900	₹50
Call (Sold)	17,300	₹50

In this scenario, the premium received from selling the call option (₹50) offsets the cost of purchasing the put option (₹50), resulting in a net zero-cost transaction.

Payoff Chart

In a zero-cost collar strategy, the investor’s payoff is limited between the put and call option strike price. The payoff chart also shows the possible stock values considering various expiry levels of the Nifty index.

Nifty Expiry Level	Profit/Loss from Stock	Profit/Loss from Put	Profit/Loss from Call	Net Position
Below 16,900	Losses increase below this level, but the put limits loss	Gains from put	None	Limited loss
Between 16,900 – 17,300	Stock value changes based on market	None	None	Within range, no option payoff
Above 17,300	Gains increase	None	Loss from call increases	Capped gains

The payoff chart clearly shows that:

• If the index falls below 16,900, losses are limited by the protective put option.
• The profit is limited if the index goes higher than 17300 because the call option requires the investor to sell at this price level.

Scenario Analysis

To understand this strategy better, let’s analyze two different expiry levels: one below the put strike and one above the call strike.

Scenario 1 – Nifty Expires at 16,900

If Nifty closes at 16,900:

• Stock Position: The investor loses as the index drops but this is provided for by the put option the investor buys with the stock.
• Put Option: The put option comes into operation at 16,900, whereby the investor can get out without further loss.
• Call Option: It is used as a call option that expires without the need for the investor to buy at a higher price.

In this case, the investor realizes the advantage of protective put, which has a maximum exposure to loss that the investor is willing to undertake.

Component	Profit/Loss
Stock Position	Limited loss
Put Option	Gains from protection
Call Option	None
Net Position	Managed loss

Scenario 2 – Nifty Expires at 17,300

If Nifty closes at 17,300:

• Stock Position: The investor realizes a gain as the index rises.
• Put Option: The put option expires worthless, as it was out of the money.
• Call Option: The call option, however, now obligates the investor to sell at 17,300, limiting additional gains above this point.

Here, the investor’s gains are capped at 17,300 due to the call option, but they still benefit from the appreciation up to that level.

Component	Profit/Loss
Stock Position	Gain up to 17,300
Put Option	None
Call Option	Capped gain
Net Position	Limited profit

Conclusion

The zero-cost collar strategy is thus profitable and provides a good hedge for the Indian portfolio investors who desire protection against steep price declines without having to pay a prohibitive price for the same. The advantage of limits and notations is that they allow the investor to control risk and set in advance the limits of the possible interest rates.

This strategy is especially adopted at Indian markets because stock and index also have a high level of volatility affecting longer-term portfolio fund. A zero-cost collar directs potential losses toward their maximum, and simultaneously provides limited upside appreciation potential within a pre-specified range.

• Author: Religare Broking
• Last Updated: November 26, 2024