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It is an 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, which puts a restriction on the loss rate; nevertheless, it can also restrict profits.
The strategy involves the purchase of put options and the use of out-of-the-money-covered calls.
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 price 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 that can limit losses to 10 per cent and sell the 6-month call on the same fund, limiting 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 an accurate interpretation of the strategy, it is necessary to understand the true cost involved, including the opportunity cost.
It can be applied when the fund ends in 6 months term within a range of a 10 per cent loss and a 5 per cent gain.
Such a strategy will not impact the fund's performance positively or negatively.
If the fund loses over 10 per cent in the six months before the expiry of such options, the investors can cap loss at 10 per cent, but if the fund gains more than 5 per cent, 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 profiles can be non-linear, meaning the outcomes can be asymmetric.
Depending on the term, the gains can be taxed at an ordinary rate than long-term gain rates.
Such complex strategies may not provide a perfect hedge for a globally diversified portfolio.
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