Jun. 28, 2018
Insight Series – Comparing Hedging and Options Strategies
With a collar strategy, the manager typically has a long underlying position in a portfolio of stocks. The manager seeks to protect against downside risk by purchasing an out-of-the-money put option. While it is certainly prudent to protect against downside risk, put options obviously cost money.
To help offset the cost of the put options, a collar strategy seeks to generate income by writing out-of-the-money calls against their market position. In effect, this caps the upside potential of a collar. This is the fundamental trade-off of a collar strategy: downside protection is purchased in exchange for selling away some of the upside potential.
A collar typically has three components:
Below is a graph outlining the return profile of a covered call strategy.
A “Protected” Covered Call
If the above chart looks a bit familiar, it should. The collar strategy is closely related to the covered call. In fact, two of the three legs of the collar are the same as the covered call: the long equity position and the short call position.
With the covered call strategy, we stated that one of the drawbacks is there is no downside protection. One way of thinking of collars is that they are essentially “protected” covered calls: using the premium they generate from the short calls not for income but to purchase downside protection.
The primary driver of the collar strategy’s returns is the movement of the market itself. Not only is the direction of the market important but the degree or magnitude of the market’s move is also significant. It is often said that a collar is a moderately bullish strategy.
The key word is moderately. Since the core of a collar is a long position in a portfolio of equities, the holder obviously hopes that the market goes up. However, the risk is if the market goes up too much, the call options will go from being out-of-the-money to being in-the-money. Under such circumstances, the portfolio manager really only has a few options.
One, they could close out the trade and take a loss on the option trade. Two, the underlying asset could be called away and miss out on the gains. Or three, the portfolio manager could cross their fingers and pray that the market reverses direction and dips back below the strike price before being called. Either way, the collar has effectively sold off its upside potential in a sharply rising market.
Of course, the benefit to the collar strategy is when the market goes down. If the market goes past the put strike and if the collar was implemented correctly, the strategy should be protected from losses beyond a certain point.
That is why the strategy is called a collar: The range of returns is meant to be “collared” with limited downside but also limited upside.
The first risk is the most obvious one: that a collar strategy has sold off its upside potential. This is more of an “opportunity cost,” where gains beyond a certain point are forgone. However, there are additional risks to a collar. As always, the devil’s in the details.
Paying the Price for Puts
One risk has to do with what’s known as the skew of option pricing. In layman’s terms, skew refers to the fact that the prices of put options are usually significantly higher than the price of call options. If a collar strategy is buying high-priced put options and hoping to offset the cost by selling low-priced call options, the collar might not be generating premium to fully pay for the put.
This leaves the portfolio manager with some difficult choices.
Potentially Expensive Protection during Bear Markets
The other major risk to a collar strategy is the cost of maintaining it through a prolonged bear market. When collars are established, the protection is usually short-term in nature with the puts going out three months or so. Sometimes more, sometimes less, but three months is typical.
What happens to a collar strategy during an extended market downturn after its initial hedge is cashed in? If the collar is to be maintained, new put options will need to be purchased. But in a protracted bear market like the dot-com crash (2000-02) or the Global Financial Crisis (2007-09), buying new puts every quarter can become prohibitively expensive. The price for short-term protection skyrocketed in such environments and, in some cases, maintaining a collar might be impossible thus leaving the underlying unprotected from downside risk.
There is no “silver bullet” strategy that works well in every situation. Every strategy has environments it works well or works poorly. Collar strategies tend to work best in either modestly upward markets or short-term, minor corrections of 5%-10%.
In the case of the former, the collar will enjoy modest gains without too much upside called away. With the latter, the short-term put offers some protection, and hopefully the sell-off isn’t too steep or too prolonged. A case can be made for having a portion of one’s portfolio in such a strategy.
However, if one expects to capture most of the upside in a strong bull market or if one is looking for bear market protection, a collar is not likely to be the best fit.
The story isn’t much different with the balanced 60/40 portfolio. Although the highs aren’t as high and lows aren’t as low, the general picture remains the same.
A “glass-half-full” optimist would argue that the portfolio has maintained a fairly aggressive level of withdrawals and is holding up well during the distribution stage. Conversely, a “glass-half-empty” pessimist would wonder how many more years of spending the portfolio could maintain and would be rightfully frightened of another bear market sell-off.
Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.
Marc Odo, CFA®, FRM®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.