KNOWING ALL OPTIONS
A variety of options strategies provide capital protection for equity-based portfolios. The most obvious choice is the use of protective puts. However, protective puts tend to be relatively expensive, especially in periods of high volatility.
Another options-based approach is the buy-write or covered call strategy. The covered call strategy entails the writing of call options against a long underlying position, typically at a one-to-one ratio. Several empirical studies have suggested that covered call writing can enhance returns as well as mitigate losses from market downturns. However, covered call writing still leaves an investor exposed to large down moves.
The collar strategy essentially adds a long protective put to a covered call strategy. This addition provides significant downside protection, which the covered call lacks. The purchase of the long put is financed by the sale of the call. In essence, the collar trades upside participation for downside protection. A tight collar provides less upside participation and more downside protection than a loose collar. At one extreme, the tightest collar using at-the-money (ATM) puts and calls effectively immunizes the portfolio from market movements. At the other extreme, a loose collar uses far out-of-the-money (OTM) puts and calls. Between these far OTM strike prices, the collar is essentially equivalent to a long underlying position.
The research assessed the effectiveness of the passive and active variations of the collar strategy from March 1999 to May 2009. The analysis considered a number of implementations of long collar strategies with varied moneyness of the puts and calls, as well as times to expiration. In addition, the collars’ performances were analyzed with the time period segmented into three sub-periods. These sub-periods feature different market environments reflecting conditions generally favorable and unfavorable to a collar strategy.
The protective collars significantly outperformed the QQQ in the overall period, as well as in the periods covering the technology bubble and the credit crisis. While the collar variations underperformed the QQQ in the interim period between 2003 and 2007, in all of the implementations in all time periods, both collars significantly reduced risk compared to the buy-and-hold strategy. The study further indicated that the collar variations using six-month put purchases outperformed the one-month and three-month put strategies in almost all measures. The slower time decay of the longer maturity six-month puts was a significant benefit to this collar implementation.
Rolling standard deviations clearly showed the risk-reduction benefits of the collar strategy (“Rolling your risk” ). The collar strategies exhibited lower standard deviations throughout the entire period, with the differences ranging from five to 45 percentage points. It is also worth noting that the risk-reduction benefits of the active collar strategy over the passive collar tended to be relatively subtle, particularly when compared to the difference between the collars and the QQQ.
The passive strategy using the 2% OTM six-month put and 2% OTM one-month call generally exhibited the best performance and represented a middle ground between ATM and far OTM. This strategy uses fixed rules and does not allow for flexibility in different market conditions.
During the April 1999 to September 2002 period, the QQQ was extremely volatile and lost more than three-quarters of its value from peak to trough. Specifically, the QQQ had an annualized loss of 23.3% with a staggering 42% volatility. In contrast, the passive collar strategy generated an annualized positive return of 21% at a volatility of only 13.7%.
The collar was able to turn a sizeable loss into a significant gain while at the same time reducing risk by more than two-thirds. The capital protection ability of the collar strategy truly shines in this case. The collar could have earned investors a very impressive 21.2% per year over the sub-period with a maximum loss of capital of 7.5%, regardless of how poorly investors timed their entry into the strategy. The collar was an effective way of capturing a significant return from the bubble run-up without facing the tremendous losses that came with the collapse.
In the period between October 2002 and September 2007, steady positive returns, low volatility and few sharp down moves of the index explain why the collar strategy was expected to perform relatively poorly. The annualized return of the QQQ over this period was an impressive 20.4% at a relatively moderate volatility of 17.5%. The collar only provided a 5.2% annualized return over this period. It did, however, do so at a far lower volatility. Nevertheless, this under-performance was not nearly as significant as the QQQ’s under-performance in the earlier period.
While most asset classes became more correlated and collapsed during the credit crisis period from October 2007 to May 2009, the collar again provided significant capital protection. The annualized loss of 19.8% in the QQQ was reduced to a loss of only 1.4%, while the standard deviation was cut from 29.2% to 11.6%. Again, the strategy provided capital protection where the implementation was not a cost but rather additive to the returns of the underlying position.