Option-based collar hedges can be a great way to stay invested in stocks without exposing yourself to the same degree of losses you’d experience in a typical bear market. With the current bull market extending deep into its tenth year, the use of collar hedges, along with some other strategies we’ve written about, may be an appropriate way for you to reduce risk in your portfolio. This blog will walk you through the mechanics of how a collar strategy works and also help you develop expectations for return.

An Options Refresher

Before explaining collars, a quick refresher on options. There are two types: calls and puts. When someone buys a call (let’s say on an ETF that tracks the S&P 500), they have purchased the option, but not the obligation, to buy that ETF at a certain price. When someone buys a put, they have purchased the option, not the obligation, to sell that ETF at a certain price. And for every buyer of a call or a put, there is a seller on the other side of the transaction. It’s helpful to think of calls as a sort of raffle ticket, wherein you pay a small premium in the hope of a larger payout, and to think of puts as a sort of insurance policy, wherein you pay a small premium to protect in the event of losses.

If you want to protect your portfolio from losses, the intuition is to simply buy a put. If your portfolio loses value, the put pays off. The problem, however, is that it costs you money to buy a put. If you regularly bought puts for your portfolio, the amount you pay out in put premiums would likely eat into your investment return so much that you would no longer find it worthwhile.

That’s where the collar strategy comes in handy. You still buy puts on your portfolio, but you are offsetting the cost of it by selling a call. Done correctly, this will still allow you to enjoy some of the upside of your stock portfolio while protecting the downside in a low- or no-cost manner.

Let’s consider an example. You have a stock portfolio that mimics the S&P 500 index. You want to protect it from potential losses, so you buy a quarter-long put on the S&P 500 with a strike price 5% below where the current price is. This means that if the portfolio loses 5% or less you will lose just as much, but any losses beyond 5% are protected. Simultaneously, you sell a quarter-long call on the S&P 500 for a strike price above the current price. For this example, let’s assume it’s 5% above the current price. This means that you enjoy any returns up to 5%, above which your upside is capped. By selling the call, you have received a premium from the buyer. This received premium offsets, in part or in whole, the premium that you paid to buy a put. For very little cost to you, you have insured your portfolio against severe losses for a quarter.

There are some practical considerations that must be accounted for. For example, the put you buy may be more expensive than the call you sell. To achieve a truly “zero-cost-collar,” some managers of this strategy will also sell a put with a strike price that is significantly below the current price, for example 20% below. Applying this action to the aforementioned scenario, the investor is still protected from losses between 5-20%, but once losses exceed 20% over the quarter, the investor begins to participate one-for-one on the way down. Thus if the S&P 500 declines by 20%, you’d still only lose 5%, but if it declines 25%, you would lose 10%. Despite the added exposure to the downside, investors tend to find this tradeoff attractive because there are not many instances historically when the market has fallen by more than 20% in one quarter, and even when it does, this strategy in this example would lose 15% less than what the market does.

The collar strategy is an effective way to hedge your equity portfolio. When you’re young and accumulating wealth in your portfolio, this may be less important as you are likely focused on maximizing return. Once you’re retired, however, and taking distributions from your portfolio, maximizing return can get you in trouble. While it’s important to stay invested in equities throughout your life for their growth potential, avoiding big losses are much more important because of the detrimental impact they can have on your retirement goals.

For most investors, manually maintaining collar hedged on their portfolio can be confusing and burdensome. Fortunately, there are professional managers that offer comparable strategies in a mutual fund format. If you are interested to learn more about collar hedges and how you might invest in them, call ACG today.