Volatility dragging you down? Try option collars

To manage the latest bout of market volatility, consider adding an option collar strategy to help limit a portfolio’s downside. For the truly option-phobic adviser, don’t worry — collar strategies are not about placing a half-dozen simultaneous bets on the same security and trading all day long. When applied correctly, an option collar simply sells a call (a contract to buy) and buys a put (a contract to sell) on an underlying security to reduce volatility in the stock.

For example, an adviser who buys a share of stock at $10 could set up a collar by buying one put with a strike price of $8 and selling one call with a strike price of $12. The maximum gain, of course, would be $2, but more importantly, the loss would be limited to $2.

In a rocky market, this reduced volatility can affect performance substantially. Consider a passive collar strategy applied to the PowerShares QQQ (QQQQ), an exchange-traded fund tracking the Nasdaq Composite Index.

From April 1999 through May 2009, this ETF, offered by Invesco PowerShares Capital Management LLC, generated an annualized loss of 3.6%, with a maximum decline during any one-year period of 81.1%. The fund’s Sharpe ratio, or measurement of risk-adjusted performance (the higher the ratio, the better) was -0.22. That put the ETF below a safe asset such as a Treasury bond.

If you had applied a passive collar over the same period, the ETF would have generated an annualized return of 9.3%, with a maximum decline of 17.9% and a Sharpe ratio of 0.56, illustrating superior risk-adjusted performance.

This contrast in performance was pointed out in a 2009 report, “Collar Strategy for Fund Managers,” sponsored by The Options Industry Council, which further found that over the 122-month period, the collared strategy had 79 positive months, compared with 63 for the non-collared ETF.

The collared strategy’s highest one-month return over the period was 15.1%, compared with 23.5% without the collar. The worst one-month return over the study period was a 10% decline for the collared strategy and a 26.2% decline for the non-collar investment.

Advisers can construct their own collars, but it does require some legwork in picking the investments and managing the options. Thankfully, there are money managers who employ collar strategies in mutual funds and separate accounts.

One example of a passive collar strategy, which is sometimes used as a substitute for fixed income by asset allocators, is the Collar Fund (COLLX). Managed by Thomas Schwab, chief investment officer of Summit Portfolio Advisors LLC, the $29 million fund offers a classic example of how the strategy can provide a smoother ride through periods of extreme market volatility.

From the fund’s July 1, 2009, launch through last Wednesday, the Collar Fund was up just 3%, which compares with a 15.6% gain by the S&P 500 over the same period. But from the S&P’s most recent peak April 15 through Wednesday, the fund was down 3%, while the index lost 12%.

“We’re always going to have limited upside and limited downside. That’s why in a strong bull market, this strategy will not keep up,” Mr. Schwab said.

The steadier performance is achieved by buying a put to provide downside protection on an existing position. For example, the PowerShares QQQ,currently trading just above $44, could be protected from falling below a put’s $39 strike price by Sept. 30 for the cost of $1.54 per share.

The cost of that downside insurance typically is offset through the sale of a call, which would sell for $1.02, with the price reflecting the fact that there were dividends paid by some of the index companies. The call, which also expires Sept. 30, has a strike price of $49, which represents a limited upside on the underlying investment.

Another strategy using a collar — employed by Ron Altman, manager of the $65 million Aston/MD Sass Enhanced Equity Fund (AMBEX) at M.D. Sass Investors Services Inc. — involves the sale of calls on individual stocks that are offset by the purchase of less expensive index puts. Mr. Altman will also remove the puts during periods of higher implied market volatility because volatility increases the value of the options.

“I like to lean against momentum,” he said. “The whole concept of my strategy is to sell volatility, not to buy volatility.”

This more aggressive strategy pays off on the upside but still keeps it from falling as far as the broad equity markets. Mr. Altman’s fund gained 15.4% from July 1, 2009, through last Wednesday; it was down 4.3% from April 15 through last Wednesday.

One more twist on the basic collar is to keep the put in place but remove the upside-limiting collar in a strong market.

“The collar is our core strategy, but in a bullish market, we’ll leave the top uncovered,” said Jeffrey Beamer, manager of the $30 million Lacerte Guardian Fund (LGFIX) at Lacerte Capital Advisers LLC.

The Lacerte fund wasn’t launched until October, but from the S&P’s April 15 peak, the fund has declined by just 1.5%.

Whether you do it yourself or seek out a money manager, collars can help keep clients in the market with some sense of security during periods of market turmoil.

Related Topics: ING Group