Financial Planners and Collars

Hi Mark,

Clearly collars reduce downside risk. As a financial planner I'm
very interested in using them to help protect client portfolios. There
are some issues which I'd like your views on before treading this path
however.

1) How close to the price of the underlying should the collar be
established? My own research indicates that the more volatile the
underlying and the further into the future the option position is
established, then the 'wider' the collar should be to maximize long term
returns. On the other hand, 'narrower' collars reign volatility in
further but appear to really hurt long term cumulative returns. How
wide should your collar be? Should it be skewed eg. 10% downside
protection and 20% upside ceiling?

2) This post is all about collar adjustments. As a planner, clients
with even medium account sizes can't afford to pay someone to
continually adjust collar positions, even less so if multiple
underlyings are held. Is a 'passive' collar strategy wise eg. 3, 6 or
even 12 months out?

Thanks,

AH

***

The fact that you, as a financial planner, want to use conservative option strategies to help your clients is good news.  I have complained – on this blog and on other blogs wherever I could find them – about how financial planners have done immeasurable harm to their clients by remaining ignorant about options.

Let's begin with some general statements:

Each client has different needs, and as you would not recommend the same holdings to each client, so too, will you make slight modifications to the specific collar recommended.

Collars are going to underperform when the markets are strongly bullish.  That's the cost of owning insurance.  Be certain your client is willing to accept that fact and does not blame you for such under performance.

Collared portfolios perform extraordinarily well when markets tumble.  The greater the fall, the happier your clients will be for having taken your advice.  They will not make any money, but losses will be at acceptable levels.

Assuming you have reasonable clients, you should be able to explain that pluses and minuses when holding collars.

If the put and call expire in different months, you will earn extra money when the markets cooperate.  However, I believe they are too risky and voids the whole idea of owning a collar FOR PROTECTION in the first place.  Per the example offered by a commenter.  Mixed expiration collars are okay if you understand the extra risk involved.  That's not for a financial planner and his/her clients.

1) The first question is:  Which is more important to each client?  Is it the desire to earn as much as possible with low risk?  Or is it the preservation of capital, with the hope of earning a small return?

2) If preservation of capital is the name of the game, then it should be easy to choose the put strike price.  In a worst case scenario – and for this client that's a down market – how much is your client willing to lose over the time period covered by the collar?  If it's 10%, then buy a 10% OTM put.  If it's less, choose an appropriate put to buy.  With indexes there are always plenty of choices.  With individual stocks, it's more difficult to choose the appropriate put because there are far fewer offered.  There's a big difference between strikes of 30, 35, and 40.  It it were an index or ETF, there would be strikes every one point, giving you just the put you need.

3) If earning capital gains is the
objective, then I'd begin by choosing the call to sell because that caps
the upside.  Then perhaps it would be easiest to buy a put that costs
essentially the same as the premium collected from the call sale.  This is
the 'no-cost collar.'

Profits are the goal, but losses must be capped at some point.  You buy a put that is less expensive offers less protection against loss.  How much the client is willing to pay to own the collar will determine just which put to buy.

Keep in mind that paying a debit means the client will lose money when the market is steady to slightly higher.  That may not sit well.  Those zero cost collars don't always provide the best strike prices, but if the client does not understand the details of what you are doing for him/her, then you ought to adopt middle-of-the-road methods that offer the best protection you can afford to buy – given the circumstances.  The person who wants to sell calls that are 20% OTM is not going to be able to afford to spend much for put protection.  In fact, I'd suggest that if the client is that bullish, perhaps a collar is not the best choice.

If trading indexes or exchange traded funds (ETFs), you can assume they won't drop 30% overnight, but as we have seen, 50% in one year is not impossible, and owning puts is beneficial.

For this client, there is no easy way to pick the put strike price becasue protection is not the top priority.  Perhaps you can decide how much to pay for puts ad make the decision that way.  This would result in far less protection now, when markets are volatile (and everyone wants to own protection) and more protection when markets are calmer and option implied volatility is lower. 

4) If you follow the advice on choosing the put to own, and if you allow your pocketbook to determine how much to collect when selling the call, the first question becomes unimportant.  It just solves itself.

5) There is no reason to make a client trade more often than necessary.  I'd look to trade 12-month collars for clients who are not interested in active trading.  More than that, I'd encourage them to own SPY (or another broad-based index), unless you or they have displayed a talent for picking stocks that out-perfrom the market.  One ETF means only one collar trade at a time, rather than one per underlying stock.

6) Don't forget, it's not necessary to collar an entire portfolio.  Even 25% is better than none – when you want some safety.

705


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8 Responses to Financial Planners and Collars

  1. ZA 06/01/2010 at 10:22 AM #

    Mark, great blog. As an advisor in a similar position to AH I find this blog extremely helpful when it comes to developing various options platforms. This post was especially helpful as collars are the main risk management strategy we hope to utilize. Your answers have pretty much confirmed my original ideas; however, I have the following questions:
    1. We have diversified portfolios that blend passive ETFs and different active managers. As such, I was thinking that portfolio Betas (relative to the S&P 500) should be used to determine strike prices and the amount of options purchased/sold on the S&P index. For instance, if a client has a Beta of .50 and wishes to lose no more than 15% a strike 30% below the current S&P level could be used before the client would reach that 15% waterline. Likewise, only half of the portfolio would have to be used when determining how many S&P index options to purchase. Ignoring the problems with Beta (I can’t think of a better way to hedge the portfolio), is that above assumption generally correct?
    2. Given the high cost of S&P index puts relative to calls and the goal of collar (at least in our case) of downside protection, what is the danger in buying puts 12 months out and rolling calls? The shorter calls should allow to take greater advantage of positive Theta and looking roughly at the math may turn out to cover the cost of the puts (I realize there is no way to calculate this), while the longer dated put would provide the desired hedge.
    3. Does is make sense to actively manage the collar or just let the strategy run its course? While there certainly are situations when one might be more beneficial, is there a broad explanation? I was thinking of selling the put if it is in the money and using the proceeds to by an at the money put or rolling up calls on the upside.
    4. Similar to the question above, does it make more sense to close the position prior to expiration or let the options become exercised, if possible.
    Given the length of the questions, I understand if you can’t get to this. Regardless, thanks again for the very insightful blog and I look forward to learning more from you in the future.

  2. Mark Wolfinger 06/01/2010 at 10:50 AM #

    Thanks Zach,
    If I understand correctly, you don’t want to collar the specific positions you own, but prefer to buy puts and sell calls on SPX. Is that correct?
    This is a good question and the reply is lengthy.
    I’ll post it tomorrow morning as a separate post.
    Thanks for the contribution

  3. ZA 06/01/2010 at 11:12 AM #

    Correct Mark. We use ETFs, mutual funds, and private managers so using options on specific positions is either impossible, too costly (transactions costs), and/or hard to monitor. As such, we have basically decided that we were going to use index options or options on SPY (although I would prefer the index in case something crazy happened with the ETF) given the liquidity and the ability to use beta to manage the risk.
    Thanks for all of your help on this. I really appreciate it.

  4. Mark Wolfinger 06/01/2010 at 11:18 AM #

    My pleasure.
    I have NOT managed a portfolio this way. But I have suggested it previously and it should work fine. With the understanding that there is the risk that beta may drift significantly
    SPX options require 1/10 as many contracts as SPY options – and that makes it better.
    Of course, the ETF problem mentioned should not be ignored.

  5. Brendan 06/01/2010 at 9:00 PM #

    Great questions, ZA!
    Did you know that The Gateway Fund (GATEX) has been (mostly) collaring a portfolio of stocks that are highly correlated to the S&P500 with SPX index options since 1988 by selling ATM or slightly OTM calls to finance OTM puts (I believe they were moved to add puts to the buy-write strategy they’d been running since 1977 after the 1987 crash). The “mostly” parenthetical above refers to the fact that, at times, they won’t fully protect the portfolio (so it’s not a true collar fund like COLLX). They seem to have done a reasonable job of collaring with SPX index options net of expenses (as their performance nearly mirrors that of the CLL index since 1988, which passively writes 10% OTM 1-month calls to finance 5% OTM 3-month puts and itself boasts a solid risk/return profile since June 30, 1986).
    The OIC also produces some nifty papers for planners and institutional clients re. how to collar with index options (the latter from the perspective of a mutual-fund manager).
    Looking forward to reading and thinking about Mark’s thorough follow-up message to your thought-provoking inquiry tomorrow!

  6. ZA 06/02/2010 at 7:51 AM #

    Thanks Brendan. I am just about to read Mark’s reply. I was wondering if you could link to those OIC papers? I looked at the website, but was unable to find anything.

  7. Mark Wolfinger 06/02/2010 at 8:26 AM #

    Brendan,
    Appreciate the information re OIC and GATEX

  8. Brendan 06/02/2010 at 5:53 PM #

    No problem, but please forgive me as the papers are actually on the CBOE website (helpful stuff exists under the advisor link but what you’re looking for is in the institutional link). Here’s a sample: http://www.cboe.com/institutional/portfoliocollar.aspx. Check out the 2001 white paper re. mutual funds & options too.
    GIA.com has more in-depth info. re. GATEX, by the way.
    Take it easy.