ADVERTORIAL - By using strategies like the “collar,” investors have a solution for market risk that can provide best of both worlds - protection at a reduced cost. Here, Gary Delaney, Director at The Options Industry Council, provides you with strategies for trading options that will help protect your portfolio against market risk.
Investors want the best of both worlds. They want upside participation in the market but don't want to lose their shirt if things go sour. They want protection but don't want to pay too much for it. Anyone involved in investment decisions is used to addressing these conflicting tensions. The world of equity options is no exception. The use of options as a protective risk management tool is well established but cost can often be a stumbling block.
One way of reducing the total cost of option protection is to implement the “collar” strategy. The collar is a two-part strategy: buy a put below the market (i.e. out of the money) and at the same time sell a call above the market (again, out of the money) – traditionally with both options sharing the same expiration date. The call sold offsets the cost of the put bought. By adjusting the distance that the strike price is away from the current market price we can make the combined option position more or less protective and more or less expensive. The positioning of the option strike prices relative to the underlying investment is crucial. Too far away from the underlying and the protection and cost offset are too small. Too near and the call sold may be exercised, disrupting the strategy.
A study sponsored by the Options Industry Council (OIC) written by Edward Szado and Thomas Schneeweis from the Isenberg School of Management at the University of Massachusetts analyzed a variation of the traditional collar strategy by using different expiration dates for the options. They found that a long protective collar strategy using 6-month put purchases and consecutive 1-month call writes earned far superior returns compared to a simple buy-and-hold strategy as well as sharply reducing risk, as measured by standard deviation. The exception to these results was at times of very sharp market moves (e.g. the dot.com bubble in 1999 - 2000). You can read a summary of the research and its methodologies at Risk Mitigating Collar Strategy or read the full study at Loosening Your Collar: Alternative Implementation of QQQ Collars.
There is of course no silver bullet but investors need to be aware of options strategies that are available to help them protect and to enhance their investments. At the most simple, this could be buying a put or a call. By using strategies like the collar, investors have a solution for market risk that may very well be the best of both worlds - protection at a reduced cost.
For more information on the value and importance of the listed options markets, please visit the Options Industry Council at www.OptionsEducation.org.
The Options Industry Council (OIC) is an educational cooperative sponsored by OCC, the world’s largest equity options clearing house and the U.S. options exchanges. The mission of OIC is to promote increased awareness, understanding and the responsible use of exchange-listed options among a global audience of investors, including individuals, financial advisors and institutional managers, by providing independent and unbiased education combined with practical expertise.
Disclaimer: Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2016 The Options Industry Council. All rights reserved.
By Gary Delaney, Director at The Options Industry Council