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
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?
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.
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