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YOU are long on Infosys for 100 shares at the current market price of Rs 3,100 and are willing to sell the stock at Rs 3,200. At the same time you are also worried about the downside with the first quarter results due on 10th July. Hence to take care of these unexpected movements you can either go for a straddle or a collar. A straddle involves buying a call and put option. But it is an expensive method of protection.

Collars: Involve a long position in the underlying, a long put and a short call.

* In this, you write a call option with a strike price of Rs 3,200 and buy a put option with a strike price of Rs 3,000.

* These two positions along with the long position in the cash market will make an equity collar.

* The selection of strike price for both the call and put option will depend on the protection required by the investor.

* The above investor can select different sets of strike prices, for example a call option with a strike price of 3300 and a put option with a strike price of 3100 or any other combinations. In building a collar position, the combinations are many.

* A collar is similar to a spread position. The payoff of a collar has a limited profit while also having a limited loss, similar to a spread position.

* Collars would limit your upside but protects the position from a major downside.

* A collar is a cheaper method to protect against unexpected movements.

* An equity collar is a popular strategy with institutional and retail investors.

What happens to the investor holding a collar position?

In the above case, if the investor had paid Rs 10 for the two positions (that is buying the put which will lead to an outflow and writing a call option which will lead to an inflow) together.

Stock rises: If Infosys rises above Rs 3,200, the call option written will become in the money and the investor will be assigned the call. This loss will be covered by the profit earned from the long position in the cash market. Obviously the put option will not have a value since the market price is above the strike price of put option. The net profit to the investor will be Rs 90 (Rs 3,200-3,100-10)

Stock falls: If the market price falls to below 3000, the put option will turn in the money and be profitable. The investor will exercise the put option and receive Rs 3,000. The call option written will have no value. The net loss to the investor will be again Rs 90 (Rs 3,100-3,000-10). Hence, whatever the market price of the underlying, the investor is protected from one of the two options. However, both the upside and downside are limited to the extent of Rs 90.

How to construct zero cost collars (ZCC): ZCC is one where the investor is able to construct this position without any cash outflow. The inflow from the call option written is used to fund the outflow for the put option purchased. ZCC provides a cost effective method of protecting an existing investment in shares. When an investor uses a zero cost collar, he can ensure that at maturity, the value of the investment will be within a certain range, irrespective of the underlying price. This can be achieved with no initial cash outflow.

Consider the above case of Infosys again. The following are the closing price as on Friday, June 4, 2003.

We can construct a ZCC buying a put option with a strike or Rs 3,000 (cash outflow of Rs 149) and writing a call option with a strike of Rs 3,200 (cash inflow of Rs 147). The combination position will lead to a cash outflow of Rs 2, excluding transaction costs, a near zero cost collar.

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