Can someone please explain to me this concept and the disadvantage of zero cost collar comparing to a straddle? Background is the analyst bids on sharpe increase and decrease on stock price.
Is zero cost collar long put short call or short put long call?
For a collar, you want downside protection (long put) for the underlying. You pay for it by selling off your potential upside (short call). The more downside protection you want, the more potential upside you have to give up.
Under a straddle, you are long both a call and a put with the same strike price and expiry date. It pays off if there is large price movement away from the strike price.
Not sure if the OP is referring to 2010 AM #7B, but in that question you are told to explain why a zero cost collar would be less appropriate than a stradle in a situation where a company is expected to get rocked in either direction depending on the outcome of a news announcement about a bid to host a tournament.
My answer was that the short call leg was open to unlimited potential loss with the 0-cost collar if the stock moves sharply higher.
The guideline answer was
“A zero cost collar would lose a limited amount of money if the U.K. loses the bid, and would make only a limited profit (compared to a straddle) if the U.K. wins the bid.”
Why would my answer not make more sense than this? There is no implication in the question that the investor is long the underying, and most of the strategies discussed are generally used when there is no position in the underlying.
If the analyst bids on sharpe increase and decrease on stock price, you want to use straddle= LC ATM+LP ATM, which benefits from high volatility in either direction.
zero cost collar = protective put + covered call, which hedges downside risk and gives you limited upside potential.
To begin with, a collar starts with a position in the underlying; a straddle does not.
A long collar is a combination of a long position in the underlying, a long put at a low strike, and a short call at a high strike.
A short collar is a combination of a short position in the underlying, a short put at a low strike, and a long call at a high strike. The curriculum doesn’t mention a short collar.
The payoff on a long collar looks like this:
__/¯¯
The payoff on a short collar looks like this:
¯¯__
Note that a long collar is equivalent to a bull spread, and a short collar is equivalent to a bear spread.
A long straddle is a combination of a long put and a long call with the same strike price.
A short straddle is a combination of a short put and a short call with the same strike price. The curriculum doesn’t mention a short straddle.
The payoff on a long straddle looks like this:
/
The payoff on a short straddle looks like this:
/\
^ I’m surprised that a strangle strategy never made it to the curriculum. Betting on low volatility should be a given.
Instead they give us butterfly.
strangle is in reading 18.
Hmm, maybe I missed it in Schweser.
Only a long strangle. Not a short strangle.
And then, only a long butterfly, not a short butterfly.