More on Financial Planners and Collars

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.

ZA

***

Thanks ZA,

Glad to hear this blog has been helpful.

1) 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.  I'll assume that is correct.

Nothing wrong with doing that.  However, as far as your broker is concerned, this involves the sale of naked calls on the SPX.  Yes, you are covered for risk, but many brokers will not allow the sale of naked calls.  Period.  Those that do require large margin.

Do not allow this to be a limiting factor for you.  You can find a broker who will accommodate this strategy.  Of course, some clients may not want to change brokers, and you may not be able to adopt this methodology for them.

2) We tend not to use beta in the options world, and use the volatility of each ETF on its own. By owning funds of active managers (I hate the fees charged; I hope the returns justify those fees), you don't have such a volatility number and would have to calculate it – or use beta as being 'good enough.'

3) If you have a .50 beta portfolio, you are assuming a 15% move when SPX moves 30%.  If beta holds true to form, that is a reasonable expectation.  Just be aware that sometimes specific types of investments can become more (or less) volatile than one would expect and beta can change.

If you accept this limitation, using beta ought to be okay.  I'd like to avoid beta calculations, but it's also time consuming and costly (broker commissions) for your clients when you collar each investment individually. 

4) When choosing a strike price [30% OTM (out of the money) in your example], don't ignore the cost of the put when estimating the maximum loss.  Unless you plan to offset the cost of the puts by selling calls at approximately the same dollar amount.

That is a good way to choose which calls to sell – but it's a call that expires in the same month.

5) You ask about the risk of owning long term puts and selling monthly calls.

The long dated put does not provide the hedge you think it does. 

I recently posed a lengthy (2 part) description of that risk.  It is MUCH LARGER than expected.  And oddly, the downside risk is just as large as the upside risk.  This is NOT a good idea for your clients.

It may be a good idea for anyone who wants to 'play volatility' – but a customer should not be paying for trading advice from a planner.  He/she should be paying for planning advice.  Clients who are interested in setting a maximum risk level should NOT be doing as you suggest.

Yes, you can earn lots of extra dollars.  But this idea can lose bunches of money and is just not the right strategy for people who they to limit losses.  Please read that post.

Even if you decide to take this risk, you do NOT want to buy long term options when IV is high. You pay a lot for those puts and may get very poor prices for the shorter-term options. 

6) I do not believe it is correct to hedge half the portfolio. 

Assume a client has 100k, and you buy options that are 30% OTM.  If those are eventually exercised, the assumption is that a .50 beta portfolio would lose only 15k and not 30k.  That is he maximum.  You cannot buy fewer puts.

NOTE: SPX options settle in cash, so if exercised, you get some cash to offset losses beyond that (estimated) 15% loss.

7) In general you do not want to actively manage the collar.

But, that does not mean you should not take advantage of certain situations.  If for example, the market tanks and Iv moves higher, that may be a good time to do as you suggest.  Roll the put to a less expensive one, taking in cash and improving the upside.  Do keep in mind that this makes the downside worse – so the 15% maximum may be exceeded.  I'm not saying not to do it.  I am telling you to consider the new potential loss.  When markets are falling is when clients will not want to give up protection. 

It's a difficult decision.  You can earn a lot of extra dollars if you get lucky and make such an adjustment near the bottom.  That's why it's important to recognize just how much you are making the downside when making this trade.

The idea is to take out some cash – it's safer not to grab the maximum amount of cash from an adjustment.

You may also want to roll the call, but be careful not to roll too far.  That could hurt the upside.  Be certain the call still has a higher strike that the new put you own.

8)  If using SPX options, it doesn't matter if you exercise them.  These are settled in cash.  And as a reminder, these options are European style and cannot be exercised prior to expiration.

However, if you do trade ETF options for some clients, then it gets messy to exercise options and take a position in the underlying.  I would exit and roll as expiration day gets near to eliminate this inconvenience.

If you are assigned on calls, same situation.  No real problem, but it's better to avoid taking a position when you don't have to.  Just roll prior to expiration.  Pay attention to ex dividend date when trading SPY.

One more thing:  I know that many
investors find options complicated, but that is due to a lack of
understanding.  If you have clients who want to understand what you are
doing for them, please recommend The Rookie's Guide to Options.

706


Free e-book: Introduction to Options: The Basic Concepts

, , , ,

4 Responses to More on Financial Planners and Collars

  1. ZA 06/02/2010 at 11:03 AM #

    Mark, thanks for all of your help. I actually have read those posts before, but I have re-read and analyzed them, as well as your response to my questions and I have a few points of clarification. I hope you can answer them, but also realize that my questions can’t dominate your blog so if you can’t I understand. As a side note, we would probably only use collars for the insurance aspect and not to generate income.
    1. On the beta calculation I am a bit confused. Again, while Beta isn’t perfect I don’t see how else we could insure a portfolio that holds a diverse group of assets.
    I believe you agreed (with caveats) that a portfolio with a beta of .50 and desired insurance of 15% can purchase a SPX put with a desired strike of 30% below the current index levels (for simplicity I ignored transaction costs).
    My confusion comes in on how many contracts to purchase. Assuming this is for insurance, I have a $1m account with a beta of .50 and want to protect 15% down. Given the current S&P level of 1,080, I found a put at 750 for 36.90 (roughly 1 year out). If I bought 5 contracts at that price wouldn’t my portfolio be insured? Say the S&P falls by 35%, the value of my stock & bond portfolio would be $825,000 (given the beta). I would have paid $18,450 for the puts (5*100*36.90) and when I exercise them at 700 I will have gained $25,000 ((750-700)*100*5), which nets the options gain at $6,550 and gives my portfolio a total value of $831,500 and a loss of a little over 16% (higher given the premium cost). I have run the numbers at higher loss levels and get the same results – the portfolio loss is limited to roughly 15% with five contracts. Am I missing something in my math (note: I got this from the Series 4 Kaplan book)? This is troubling to me because your explanation makes sense, but my numbers are giving me the desired insurance.
    2. With regard to “the long dated put does not provide the hedge you think”, is this because of the following reasons: (1) If you pay up for IV when it is high and IV goes lower the put losses value? This is also why buying longer dated puts and selling shorter dated calls can be risky. (2) The delta is lower given the longer expiration date? (3) If the market moves up, your puts decrease in value and probably no longer provide the desired hedge?
    3. Assuming the above assumptions are correct, if the goal is pure insurance are those points negligible? I believe you outlined this in the post “Q & A. Stretched Collar (LEAPS Puts and Short-Term Calls)”. That being said, if IV is high (say like now) then maybe shorter dated puts will prove more beneficial in the long-run.
    Again, I want to thank you for your help and hope you can clarify those few questions/statements, but I understand if you can’t. I feel like even answering them probably feels like running in circles to you. Our firm is just trying to find a good way to manage risk and insure portfolios, options seem like the best way (and I loathe structured notes). Thanks so much and keep up the good work. When we start introducing options to our clients your book will certainly be the go to we recommend.

  2. Brendan 06/02/2010 at 6:14 PM #

    I have really enjoyed reading and learning from your questions and Mark’s replies, ZA. A few other thoughts in no order…
    – I’d add variable annuities to the structured-note sentiment.
    – SurlyTrader.com has some thought-provoking ideas re. hedging with the Barclays VXX/VXZ ETNs. I still prefer collars, though.
    – Mark’s “Rookies” book is the best!
    – Even if the beta of your portfolio is .50, couldn’t you still have a portfolio that’s very-highly correlated (r2?) to the S&P500, and would that affect the way you look at how to set up your collar w/ SPX index options? Confession: I haven’t thought this one through much as it’s time to put my kids to bed. Just curious… .
    Take care.

  3. ZA 06/03/2010 at 12:31 PM #

    My knowledge of R2 is that it explains what % of movements of the independent variable can be explained by the dependent variable. On the other hand, beta gives indicates how much the independent variable has moved relative to the dependent variable. As such, a high R2 (0 to 1) can indicate that the movements of the independent variable can be explained by the movement of the dependent variable and thus make the beta calculation more significant.
    Note: the independent variable = a portfolio and the dependent variable = S&P 500, for example

  4. Mark Wolfinger 06/03/2010 at 2:28 PM #

    Beta can be used per your description. There is the risk that beta may be .50, but in a bearish scenario (the problem scenario), it may increase to .60 or higher. But one can make a reasonable estimate of future beta based on past beta.
    The reason that beta is ignored in the option universe is that options are priced on the volatility of the underlying asset. There is no value in comparing the volatility of one thing to another.
    It’s the stand alone volatility that determines how much an option is worth. More than that, it’s the future volatility that counts (the time period during which you own the option), and that can only be estimated.
    Whereas a .50 beta portfolio is likely to remain near .50, the volatility of a stock may be 30, then 70 when news is released, then 30 again. Options must be priced on expected stock price changes, and thus it’s an independent, stand alone, number.
    Implied volatility plays a huge role in option pricing. Thus, buying LEAPS and selling front month options is risky. In a true collar, you buy and sell options that expire together, so the volatility risk (vega) is small.