Zero cost collars offer an attractive and inexpensive way to hedge financial assets such as interest rates, commodities and equities. A zero cost collar is the simultaneous purchase of a put and sale of a call or vice versa depending on whether you are a producer or consumer of the commodity. For the purpose of this explanation we will use the former.
The hedger determines the minimum price that they are willing to receive for the underlying commodity and buys a put option at that strike price. The hedger then determines the strike price of the call option that will need to be sold in order for the strategy to be zero cost. In essence, the hedger locks in a price that it will receive for the commodity within a range or channel with the maximum price being the call strike and the minimum price being the put strike. Hedgers use zero cost collars for the number of benefits that they offer over other hedging methods.
The zero cost collars can offer cash flow benefits to a company as it smoothes the volatility of revenue streams as well as offer more accurate cost projections. A zero cost collar does carry a margin requirement due to the writing (selling) of the call option. With the writing of the call option, the hedger has in effect locked in the maximum price it can receive but has effectively put a floor on the amount they can receive for the commodity. If at maturity the strike price of the put minus the price of the commodity at expiration is greater than zero, the put writer will pay the difference.
One potential disadvantage of using a collar as a hedging tool is that it caps the upside potential of a positive price movement in the commodity. Writing a call forces the hedger to sell the commodity at the strike price if the price of the underlying is above the strike price at expiration. This concept can be best illustrated in an example.
A silver mine has a risk that silver prices will fall below the cost of production. In the collar strategy the miner will purchase silver put options to protect against downward movements in the silver price. The first step is to determine the lowest price that they can receive to cover their costs and still make the desired profit. With this data the required strike price of the put option is determined and the option premium is measured. Put options with higher strike prices that are closer to the current price offer more protection and thus are more expensive.
Assume a current silver price of $41.40.
A silver updates miner requires a silver price of $35.00 per ounce to meet their business targets. They want to protect themselves at this level, but they also want to have some upside benefit from an upward movement in the price of silver. This protection is required out to December of 2012. The cost of a December 2012 Silver $35.00 put option is $4.51 per ounce. This would be expensive protection if one were to simply purchase the put option at $4.51 per ounce.
However December 2012 Silver $50.00 call options are trading at $4.96 per ounce. In this case the silver miner would sell the $50.00 call option generating proceeds of $4.96 per ounce and use those funds to purchase the $35.00 put option at a cost of $4.51. In this case the pair of options would actually generate proceeds of $0.45 per ounce which can be used to cover transaction costs.
Though this is technically not zero cost the difference is negligible. You can also adjust the strike prices to whatever ratio is desired. When we look at the possible outcomes for the final value of the expired options we can see that the net price to the silver mine is essential "collared" between $35.00 and $50.00 per ounce.
Chart #1 below indicates the financial payout from the collar at various silver prices at the time of expiry. Chart #2 combines the financial payout of the options with the proceeds from selling the physical silver produced by the silver mine. The effective silver price realized by the silver mine is bounded between $35.00 per ounce and $50.00 per once.
The US Dollar had moved up somewhat, but the prognosis for the dollar is not positive! The boost actually may be coming from other countries. The Swiss politicians support measures taken by the Swiss National Bank to suppress any potential rallies and stabilize the currency.
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