Modified Collars

Reader 'X'  posed an intelligent contribution to the discussion on collars.  The suggested strategy modification is important and contains additional original thinking.

I'm reproducing the conversation here for a wider audience.


X said:

On a related note, I'm not doing collars but something similar in my accounts.
If you look at S&P since 1920, it went down more than 35% down
in a year only 2 times (1929 and 2008). Thus there is no reason to buy
straight puts (especially when the volatility increases, it becomes

So you can actually buy a vertical (buy PUT at the money, sell a PUT
20 to 30% lower). This reduces your protection (can still have a major
black swan though), but historically it still protects you against 99%
of the market drops. And the cost is cheaper (we are saving 20-30% or
so on the cost of the protection).

And then there are a couple of things to avoid, like if market drops
suddenly big time, don't sell call 10% OTM on the low price but where
it was before the drop (and don't sell if the credit is nothing). As
the market can go up very quickly too (like in March 2003 and March
2009). If the market stays down, you lose the potential credit but you
are much better than the buy-and-holders anyway. If the market goes up,
you are not missing anything. And when the period is very volatile, 3
months protection is better (as the vertical is more expensive). If the
vol is down, a longer period is better. When the market goes suddenly
way up, you are missing some opportunities (but it happens every 5-10
years or so), but in all other drops you fare much better.

When the market drops, you can also roll down your long PUT (being
deeper ITM, the extrinsic value becomes smaller – although vol increase
may do the opposite). So if you roll your long PUT down, you can
actually lock the profit in case the market goes back up.
Finally during big moves, you can also sell verticals when the
charts are really over-extended to get more credit for the protection.
It works on the downside (you bring back the risk but you are also in
better position than a buy and holder so you can afford it more) and on
the upside (do we really all believe that we can rally by 50% or more
in 5 months and continue even longer? Yeah it happened in 1929, before
dropping 70%.

And BTW none of these are timing the market. Just simple hedged
strategy. If one wants to time the market and has a real idea of the
direction, then you can use this strategy and play some directional
diagonals. The risk is pretty minimal if setup correctly and still it
has an happier ending than buy and holding. It is more involved though
but can significantly increase the return (like 2x without the 2x drop
if things don't go your way).



Hi X (US Steel?),

Thanks for this important note. It reads like a well thought out plan.
1) The advantage to buying the put spread – per your suggestion – is
that you get to own the ATM put, rather than one with a larger
'deductible.' The disadvantage is (obviously) the limited coverage.

Overall, I do like the idea of owning the ATM put. But this will not
satisfy everyone's comfort zone. Is it better to avoid the 5%
deductible and give up black swan protection? Not an easy decision.

Off the top of my head it seems to me that one could compromise by
buying a cheap put (40 to 50% OTM) for protection against an
unprecedented total disaster.

2) By paying less for the put spread than you would pay for naked
long puts, you can, if you want to do so, sell higher-strike call
options, giving yourself a better upside play.

Or you could sell the same call and keep the extra cash. Writing
calls (BXM strategy) performs at least as well as buy and hold (over
the past 21 years), and 'keeping the cash' seems to be a better play.
But, it just makes your idea even more flexible.

3) There is one point you are not considering when you state that the market has been down 35% only twice. During any large market downturn is when investors get scared and may panic.

Consider this scenario: The market declines by 20%; your protective
put is about to stop providing protection because the strike price of
the put sold (as part of the spread) is rapidly becoming an ATM put.
Will the investor panic? Granted, being protected against that initial
20% decline would provide that investor with a sense of security. But
with protection running out, what would happen?

I don't have the answer. Being so far ahead of the game (losing
nothing during a free-fall), that investor could afford to spend money
on additional protection.

One could close the original spread (what you referred to as
'locking in' the profit) and open a new one. Better yet, the investor
can buy an ATM put and sell TWO OTM puts (assuming he/she already owned
that cheap put as part of the original position).

This is a difficult choice: And it's the same choice investors
who routinely sell OTM options face. Do you want to 'save money' with
the put spread [equivalent to selling OTM options and collecting the
'income' every month] and be very happy with the result most of the
time. In fact, it's more than 'most' of the time. It's almost all the
time. But occasionally the cost of selling those far OTM puts is very
large. And not necessarily because the market moves through the strike
price and continues. Often that loss occurs because the strike price
becomes threatened and the investor covers the trade at a big loss.
It's not so easy for the option seller (when selling naked) to close
one's eyes and hope for a good outcome.

I grant you there is a huge difference between selling a naked OTM
put and having the market move far enough so that your portfolio –
previously protected 100%, loses it's protection. I agree that having
an extra, viable choice is a good thing.

4) Changing the 'usual' policy of deciding which call to sell is
'timing' the market. But I believe one can be forgiven for doing that.
There is far less need to sell those not-too-far-OTM calls after a big
decline when that decline has not cost the investor any money. With
little, or no loss to hurt the investor's portfolio, there is far less
need to try to 'get some money back' by writing calls. As you state,
one can play for the big recovery and forgo writing calls.

5) As far as rolling down your long put goes, I have a quibble. You
don't really have a 'profit' to lock in. That profit in the put option
represents the loss you did not incur because you owned the put.
Nevertheless, rolling it down – or perhaps closing the original put
spread – is one way to say 'thank you' for the insurance, and holding
the portfolio unprotected (or as mentioned above, open a new put

The problem – and it's a real problem – with this idea is that
investors may feel the market 'has declined enough' and rush to take
that 'profit' and lose needed protection. It will be tempting to forget
that the put was not purchased to make money, but as an insurance
policy. The danger is that the investor may feel great about being
insured, believe he/she is a market-timing genius, and sell out
protection well before the market bottoms. I know – that investor is
still 'better off' – but investing is not a competition.

6) I would omit your vertical selling plan based on the charts, but that's my comfort zone.


I do like your ideas. How long have you been doing this?

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