Summary: The stock markets experienced a positive start this year; since mid-February, however, prices have faltered. This article introduces you to an options structure called a collar, which protects you from large price declines, but allows you to maintain a position and even profit when prices rise.
An option collar: reducing downside risk while maintaining some upside potential
Stock markets got off to a strong start to the year. By mid-February, global indices were up about 10%. Sticky inflation, further rising interest rates, tightening monetary policy and central banks deleveraging balance sheets caused the markets to falter from then on. With the bankruptcy of Sillicon Valley Bank and the mounting tension around Credit Suisse, turbulence in the stock market has intensified in recent weeks. It makes investors - who regularly hover between hope and fear - look for ways to protect their portfolios. One way to reduce risk while maintaining upside potential - markets sometimes recover faster than expected - is to use an options collar.
A collar has three building blocks:
In short, the long put is an insurance policy on the underlying position, and the short call is a way to somewhat reduce the insurance premium paid.
Typically, the strategy - which is also popular with professional investors - is applied to individual stocks. However, it can also be done relatively easily at a portfolio level if the portfolio is in close correlation with the broader market. The examples below will assume the “portfolio” equates to a position in the S&P 500.
For convenience, in this article, we do not take into account possible dividends or market liquidity (spreads).
For our example, let’s assume a position/portfolio value of about US$400,000 (current S&P 500 value of 4,000 times 100, the contract size for options on the index) and you want to go on summer vacation with peace of mind, concerned about recent market turmoil. By the way, one can generally divide all the calculations by 10 for a $40,000 position/portfolio using options on the SPY ETF, which tracks the S&P 500 cash index (price is the index divided by ten.)
Back to the example. The idea of the collar is that you buy a Sep ’23 put on SPX with a strike price of 3,850 and sell a call for SPX Sep '23, strike price: 4,400. At the time of writing this article, you will pay just under US$145 for the put. As with options on individual shares, you have to take into account the contract size of 100, so you will pay about US$14,500 in premium (cost of the option). For the call, you will receive almost US$60, or US$6,000 in premium.
On balance, the premium is $8,500, and the structure gives you protection for any downside beyond 3,850 points in the SPX index until the third Friday in September. You can visualise this in your account; see Figure 1 below. (by the way, being long the underlying while simultaneously owning the collar, as discussed below, prevents any loss on the position beyond the call strike price.)
As an investor, it is important to understand how different scenarios impact your position. First, I’ll discuss the situation of a large decline, then that of a recovery (rise). I’ll conclude with a sideways movement of the market.
With a collar position, the investor will still lose on a market drop, but only up until the maximum risk point, which is reached at the strike price of the long put “leg” of the collar, which, in our example, is at 3,850 at September expiry, or $23,500.
If 3,850 is the index level at expiry, the profit/loss of the structure is:
Loss on SPX position -$15,000 ($400,000 less $385,000)
Cost of 3,850 put premium: -$14,500 ($145 x 100 x SPX)
Premium of 4,400 short call: +$6,000
Total P/L: -$29,500 + $6,000 = -$23,500
In percentage terms, the maximum total loss is -5.75% (-23,500/408,500). We use 408,500 because of the extra cost of the options collar. Note that this loss is the same at September expiry whether the S&P 500 is at 3,850 or 3,000 or even at 0 for that matter. That’s because the value of the put on expiry rises 1:1 as a function of the fall in the underlying SPX position as the put moves “into the money” (below the strike price).
Had you never bought the collar, your loss at 3,850 would only be $15,000 dollars, it should be noted. The same maximum loss (-$23,500) in the underlying in USD terms would be at 3,765.
One advantage of owning long options is the flexibility for follow-up action before expiry. Let’s say that the market falls badly before September expiry and is trading around 3,600, a large 10% market drop. The call premium is now way out of the money (800 points, or 4,400-3,600) and is only worth perhaps $7 x 100, or $700, while the 3,850 put option is now deep in the money (250 points, or 3,850-3,600) and still has some time value remaining – let’s say it is worth $302.00 x 100, or $30,200).
At this point, the collared position looks like this:
Overall, with this sharp drop, the approximate result is a loss of -$19,000. That's 4.65% of the initial investment (19,000/408,500), far less than the 10% loss for the S&P 500 (drop from 4,000 to 3,600). Just keep in mind that the example above is an example only and will depend on time remaining to expiry and implied volatility levels used to calculate options prices.
What now? At this point, you can continue to hold the position, which will result in the $23,500 loss discussed above if the SPX is trading at 3,850 or lower at expiry. But you can also take profit on the collar (sell the put and buy back the call) and keep the underlying position if you expect the market to recover. If the market subsequently recovers to 4,000, you will have an overall gain of $10,500 ($400,000 value of SPX position + $19,000 profit on the collar less $408,500 from starting point). If, on the other hand, the market falls further to 3,400, you will have a loss of -$49,500 ($340,000 new value of SPX position less $408,500 original risk plus +$19,000 profit on collar).
Suppose the stock market doesn’t drop any further, but instead resumes the advance of the beginning of the year? How would the value of the portfolio develop? Basically, the short call strike price is the “cap” or maximum profit level for a collared position. If the index is at 4,400 on expiration, the underlying equity portfolio has risen from US$400,000 (index 4,000) to US$440,000 (index 4,400). A gross profit of US$40,000. Taking into account the collar cost of US$8,500, a net profit of US$31,500 remains in this situation. That's 7.71% (31,500/408,500). Not bad for a strategy set up primarily to reduce risk. To be clear: even if the S&P 500 is at 4,600 or 5,000 points, the maximum result remains US$31,500 (7.71%). In this situation, do take into account cash settlement of the short call.
Good to know: if the rise of the S&P 500 occurs gradually over time, the maximum result only comes into view towards the maturity date of the options.
Suppose the S&P 500 floats around aimlessly near 4,000, what does this mean for the overall portfolio? In this scenario, the $8,500 collar net premium cost will slowly decline in value as it loses time value and expires worthless at expiration. This $8,500 is therefore the maximum loss in this scenario, or 2.08% (8,500/408,500).
Time decay is a gradual process. For this example, let’s simulate what our collar with the same strike prices looks like three months down the road by looking at options for the same collar that expires in June rather than September.
The value of the put would go from $145 to approximately $95. So the put loses $50 (US$5000) in three months. And the 4,400 call price drops from almost $60 to about $20. Since you initially sold the call, this means a profit of $40 ($4,000). In total, the collar will cost you an estimated $1,000 in three months. Of course, the actual result may differ somewhat.
What else? Should the index move sideways for three months, but you still don’t trust the markets, you can choose to close the 'September collar' and take your loss of about $1,000. You can then set up a new collar. For example, again a long put 3,850 and a short call 4,400 but extend the maturity until December 2023.
A collar allows you to build in a certain amount of protection. It is not a construction for pursuing high returns. It is a safety belt for the underlying portfolio while maintaining some upside potential if the underlying instrument rises.
Of course, there are any number of variants of this approach. Depending on your risk profile, you can vary the strategy, for example, considering puts that are farther out of the money, calls that are closer to the money (which makes the collar cheaper, but limits profit potential), selling the legs of the collar at different times depending on what the underlying is doing, or even using call and put legs with different maturities. Options offer a huge range of, well, interesting options for the investor.
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