You have to be in detailed view (shortcut Ctrl D).
The option to collapse items in version sets applies to a single version set with amm its components already expanded and visible in the browsing space. Its effect is to hide all versions under the 'top of version set'. You only have to click on the small triangle icon on the right of the thumbnail to switch between 'collapse' or 'expand'. Or you use the menu Edit >> version set or you right click on the thumbnail and you get the same version set menu.
Collapsing is different from 'flattening' which is keeping only the 'top of version set' and deleting all other components including the original if it's not the top item.
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