Costless collars are one of the most-used hedging structures for commodity producers.  In this structure, the downside protection, the put option, is financed by selling a call.  In other words, the insurance against prices falling is paid for by giving up some of the upside in the case of a price rise.

The producer will set his downside protection target and then look at the call option market to see how much upside he will have to give up.  Say, for example, that the February WTI crude oil futures contract is currently at $89 and the at-the-money implied volatility is 27% annualized.  If the producer wants to limit his downside at $80, he will have to pay $.53/bbl for the $80 strike put option.  He can sell a $99.50 strike call option for $.53/bbl to finance his put (this is assuming no bid/ask spread for simplicity).

The option market, however, never has the same volatility for different strikes, despite the assumptions of the Black-Scholes and Black 76 (which is used in this example) option pricing models.  In fact, the February $80 put option is trading with a 29.5% implied volatility.  The $99.50 call has a 25.5% implied volatility.  This is because the market is putting a higher likelihood on a down move than on an up move, and the producer will have to pay more for that.

The $80 put is selling for $.69/bbl, while the $99.50 call is selling for $.43/bbl.  The structure will not be costless.  A costless structure will have to include a call with a $97.25 strike.  The producer will have to give up $2.25/bbl more of upside potential than if the volatility across all strikes was the same as the at-the-money volatility.  This is the effect of the volatility skew.  The payoff of the structure will look like this, with the producer’s price following the market between $80 and $97.25: