Volatility got you down? Turn to option collars

To manage the latest bout of market volatility, consider an option collar strategy. Option-phobic advisers take heart: There is no need to embark on a wild ride or trade all day long.

Option collars are a fairly conservative hedging technique. They allow investors to minimize risk by simultaneously writing a call option for a price above the current market price of an underlying security and buying a put at a below-market price.

The strategy reduces the impact of market volatility (as I will demonstrate shortly) by locking in a pre-defined exit price if the market falls. What makes it potentially more advantageous than buying a put option alone is that writing a call generates income that can offset the expense of the put, providing volatility insurance at little or no cost.

Let’s take a look at a collar strategy applied to the PowerShares QQQ, which tracks the Nasdaq Composite Index.

From April 1999 through May 2009, this ETF (QQQQ), offered by Invesco PowerShares Capital Management LLC, generated an annualized loss of 3.6%; the worst peak-to-trough decline was 81.1%. More depressing, the losses came with a lot of risk.

The QQQ’s negative Sharpe ratio for the period (-0.22) indicates that investors would have been better off buying a risk-free Treasury bond, which has a reading of zero on the scale developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance.

Look at what would have happened if an investor had applied a collar over the same period. The same ETF would have generated a positive annualized return of 9.3%.

Its maximum annual decline would have been 17.9%, and its Sharpe ratio would have climbed into positive territory at 0.56, indicating that the investment would have delivered superior risk-adjusted performance.

This example of a collar strategy is pointed out in “Collar Strategy for Fund Managers,” a 2009 report from The Options Industry Council, the information arm of the options exchanges. The report found that during the 122 months studied, the collar strategy produced positive returns in 79 months, compared with 63 for the non-collared ETF.

As intended, the collar strategy dampened both highs and lows. Its highest one-month return over the period was 15.1%, compared with a return of 23.5% for the collarless approach.

But the worst one-month return over the study period for the collar strategy was a decline of 10%, compared with a 26.2% decline for the non-collared investment.

If you like the collar concept but don’t want to do the options trading yourself, the strategy can be carried out passively by using mutual funds, exchange-traded funds and separately managed accounts.

The $29 million Collar Fund (COLLX) managed by Thomas Schwab, chief investment officer of Summit Portfolio Advisors LLC, is an example of a fund employing a pure collar strategy.

From the fund’s July 1, 2009, launch through last Wednesday, it was up just 3%, compared with a 15.6% gain for the S&P 500 over the same period. But from the S&P 500’s most recent peak, April 15 through Wednesday, the fund was down just 3%, while the index lost 12%.

“We’re always going to have limited upside and limited downside. That’s why in a strong bull market, this strategy will not keep up,” Mr. Schwab said.

Another strategy using a collar — employed by Ron Altman, manager of the $65 million Aston/MD Sass Enhanced Equity Fund (AMBEX) at M.D. Sass Investors Services Inc. — involves the sale of calls on individual stocks that are offset by the purchase of less expensive index puts. He removes the puts during periods of higher implied market volatility because volatility increases the value of the options.

“I like to lean against momentum,” Mr. Altman said. “The whole concept of my strategy is to sell volatility, not to buy volatility.”

This more aggressive strategy pays off on the upside but still keeps the fund from falling as far as the broad equity markets on the downside.

From July 1, 2009, through last Wednesday, for example, Mr. Altman’s fund gained 15.4%. From April 15 through last Wednesday, it was down 4.3%.

Another twist on the basic strategy is to keep the put in place but remove the upside-limiting call option in a strong market.

“The collar is our core strategy, but in a bullish market, we’ll leave the top uncovered,” said Jeffrey Beamer, manager of the $30 million Lacerte Guardian Fund (LGFIX) at Lacerte Capital Advisers LLC.

The Lacerte fund was launched in October, but from the S&P 500’s April 15 peak, it has declined by just 1.5%, versus a 3.8% swoon for the index itself.

Whether you create them yourself or seek out a money manager, collars can help keep clients in the market during periods of turmoil while allowing them — and you — to sleep better.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].