An option collar can help investors lock in profits on investments. Learn more about a tool to manage risk.
An option collar, which allows investors to establish a “floor” and “ceiling” to hedge against market downturns, can provide portfolios greater downside risk protection than the standard multi-asset diversification strategy, according to The Options Industry Council or OIC.
Interest in option collars was rekindled by the 2008 financial crisis when standard diversification strategies failed to protect investors from massive losses as “contagion” spread across multiple assets classes, including equities, currencies, commodities, fixed income and real estate, according to the OIC, an industry cooperative created to educate investors and financial advisors about the benefits and risks of versatile, but complex exchange-traded equity options.
“While option-based collars may not provide complete protection for all products and in all market conditions, collars can provide significant risk control across a wide range of asset classes, significantly reducing volatility, drawdowns, and, in certain market environments, can also provide enhanced returns relative to a stand-alone investment,” said the OIC in a statement.
An option collar combines two hedging strategies known as “protective puts” and “covered call” writing, according to the OIC. In a typical collar strategy, investors pick a call strike above, and put strike below the starting stock price in order to hedge against a longer position in the stock.
“The put strike establishes a minimum exit price, should the investor need to liquidate in a downturn,” said the OIC. “The call strike sets an upper limit on stock gains. The investor should be prepared to relinquish the shares if the stock rallies above the call strike.”
According to the Chicago Board Options Exchange, or CBOE, an equity option collar is an appropriate strategy for investors looking for a low-cost means to limit the downside risk of a stock position, and who is also willing to forego upside potential in return for the downside protection.
“Collars may be of special interest to those investors who have one equity position that accounts for a large proportion of their net worth, and who may not be able to reduce the size of this position,” according to the CBOE. “For these investors, low cost protection may take precedence over maintaining upside potential.”
A recent study sponsored by the OIC and conducted by researchers at the Isenberg School of Management at the University of Massachusetts explored the benefits of an equity collar strategy. The researchers compared the performance of the SPDR S&P 500 ETF with and without a 2 percent out-of-money collar between June 1, 2007, and December 30, 2011.The 55-month interval captured the financial crisis and following recovery.
Over the study period, the collar strategy returned more than 22 percent, while the long strategy lost more than 9 percent. According to an OIC statement, the collar earned superior returns with less than half the risk. Maximum losses for the SPDR S&P ETF were more than 50 percent, while maximum loss for the collar fund never exceeded 11.1 percent, according to Thomas Schneeweis, professor of finance, and Edward Szado, research analyst.
More than half the 607 financial advisors surveyed by the Options Industry Council in 2011 said they would recommend an option collar to lock in profits on existing investments.