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Can You Beat the Market? Searching for Answers. Part IV Collars

Parts I, II, III

The results are in for the buy-write indexes, but they are far from definitive.   Writing covered call options on a basket of stocks that mimic broad-based indexes is a reasonable play.  But I cannot conclude that it's a strategy that always makes extra money.

What is true, is that covered call writing:

Reduces portfolio volatility (good)

Enhances profits for a portfolio of large cap stocks (good)

Provides mixed results for more volatile stocks, such as those in the NDX and RUT (not as good)

Under-performs during strong bull markets and out-performs otherwise (as expected)


Personal note and a chance to vent: I have a bias towards the adoption of collars by a large segment of the world's investors.  I want to see studies that demonstrate that collars are a viable investment strategy, and not too costly.

Most investors use the buy and hold strategy because they don't know any better, take the advice of professional advisors who are more concerned with their own commissions and fees than with the best interests of the client, or just follow advice they read in the newspapers or find on many financial blogs. 

I'm not saying that buy and hold is a always a poor idea.  I have no problem with it when it's the investor's own decision.  Not when it's based on listening to someone who has a vested interest (annual fees) in telling you to hold stocks forever and continue to buy more.  None of these investors is Warren Buffett and it's not a good idea to attempt to do what he does.

Proof that investors make poor investment decisions is the trillions of dollars invested in traditional mutual funds.  These are funds which cannot perform as well as the market averages, but which are not bashful about collecting management fees for that under-performance. 

Many such funds even charge a sales load (I shudder at the thought of people wasting money on extra commissions) to be allowed to buy funds that, on average, under-perform index funds.  It's a shame that so many investors never learned how to invest. 

Avoiding mutual funds should be the number one lesson.  OK, end of rant.


It's appropriate to look at collars in our search for methods that beat the market.  The collar is a covered
call, but it also includes the purchase of a put option.  Those puts
are costly, and comparing portfolio performance for a collared
portfolio against the same portfolio (unhedged, or buy and hold) should
give investors an idea of just how much it costs to protect a portfolio
against losses.

As we have seen with covered calls, the unhedged index is going to out-perform substantially during bullish markets.  In fact, collars should do less well than covered calls because cash is spent on the puts.  But, during bear markets, those puts are extremely valuable and the results are going to depend upon how much money the puts save when they are needed compared with how much they lose when they expire worthless.

Data on collars has been scarce.  But the CBOE recently (one year ago) published the CBOE S&P 500 95-110 Collar Index.  I've described that index previously, and more details are available at the CBOE site.

As the 'name' of the collar indicates, the puts are 5% OTM (95% of the index price) and the calls are 10% OTM (110% of the index price).

As previously discussed, this collar does not scream 'use me, use me.'  It provides excellent protection when needed, but is costly most of the time.  This can be seen in the data:


The results here are spectacular.  At the market peaks in 2000 and 2007, the collar index (CLL) lagged dramatically.  It's doubtful that anyone who adopted the collar strategy would be very tolerant of his/her portfolio performance.  Yes, at the market bottoms in 2002 and 2009, the unhedged portfolios declined by enough to 'catch up to' their collared counterparts.

The single collar index for which we have data tells us that collars work extraordinarily well when needed.  But something less spectacular is probably needed to attract a large number of individual investors. 

I'm waiting and hoping the CBOE will make the data available in the form of the 95-100 CLL Index. 

[ADDENDUM: Why? It allows direct comparison with BXM, the covered call index that writes ATM calls, and not 10% OTM calls.]


At 11:30 today (CT), data from a new study will be available.  This data shows that a collar strategy can provide returns that make collars a viable investment alternative.  I'll publish another post with further details at 11:32.


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