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It is a type of option designed mostly in bull markets where the investors continue to move to a new high.
It is adopted as a hedge against fluctuation where the cap protects the trader’s potential downside.
It is the strategy where the investors possibly insure their current stocks or portfolio asset against losses where puts a restriction on the rate of loss; nevertheless, it can also restrict profits.
The strategy involves the purchase of put options and the use of out of the money covered call.
The option contract provides the holder with the rights but not the obligation to buy and sell stocks( or assets) at the specified rates for the given duration of the contract.
Buying a put gives the right to sell a security at the given price at any time until the option expires. This can act as a limit for potential losses.
To set a zero collar strategy, the investors buy a 6-month put option which can limit losses to 10 percent and sell the 6-month call on the same fund which can limit gains to 5%.
The asymmetric payoff profile is necessary to ensure the premium earned from selling the call matches the premium paid to purchase the put.
The tactic is said to be costless since the premium from the call option sold brought proceeds that are equal to the cost of the put option bought.
However, to get the accrete interpretation of the strategy it is necessary to understand the true cost involved which includes the opportunity cost.
It can be applied in conditions when the fund ends in 6 months term within a range of 10 percent loss and a 5 percent gain.
Such a strategy will have no impact on the performance of the fund positively or negatively.
If the fund loses over 10 percent in the 6 months before the expiry of such options, the investors can cap loss at 10 percent, but if the fund gains more than 5 percent, the investor will not get the gains above 5%.
The transaction can be cashless but the opportunity cost of missed profits can be higher.
Certain option payoff profile can be non-linear, which means, the outcomes can be asymmetric.
Depending on the term, the gains can be taxed at an ordinary rate than long term gain rates.
Such strategies can be complex and may not provide a perfect hedge for a globally diversified portfolio.
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