Dec 28, 2016
By: Sage Anderson
Exchange-traded equity options essentially represent an insurance market for stocks.
A variety of entities consequently enter the options market for several key reasons - to increase returns (covered calls/covered puts), speculate (long naked calls/puts), or reduce risk (protective collars, naked long puts).
A volatility-based trading strategy seeks to leverage fluctuations that occur in the "cost" of insurance. The CBOE Volatility Index (VIX) is a well-known metric that reflects the ever-changing cost of "insurance" in the stock market. The VIX does so by calculating the implied volatility of the S&P 500 Index.
When the VIX rises, implied volatility goes up, and the cost of insurance (option premiums) for S&P 500 stocks theoretically increases. And when the VIX falls, implied volatility goes down, and the cost of insurance (option premiums) for S&P 500 stocks theoretically decreases.
Depending on one's current holdings and strategic approach, it's possible a retail trader could use the options market for all three of the aforementioned reasons - increased returns, speculation, risk reduction/hedging - in addition to trading volatility.
For example, a retail investor may be sell covered calls in a long-term equity holding, purchase naked calls in a beaten down company, and/or deploy a protective collar in a stock that has run up substantially during a big rally (i.e. the “Trump rally”).
Today's blog post focuses on the protective collar strategy, which was previously featured on Market Measures.
The protective collar trade structure is typically deployed by investors that want to participate in further upside in a long equity holding, but simultaneously want to limit downside risk.
Protective collars are therefore deployed using the original long stock position in combination with a long premium out-of-the money (OTM) put and a short premium OTM call. If the trader receives more premium from the short call sale than he/she does for the long put purchase, the trade is often called a "cashless collar."
Imagine that you bought stock XYZ for $50 three months ago and that XYZ is currently trading $65. In terms of stock-only decision-making - you can either sell the stock now for a profit, or you can hold it longer hoping for further appreciation.
With options, you could limit your downside risk by purchasing puts, you could reduce your potential upside benefit by selling calls, or you could do both using a protective collar.
The ultimate decision a trader makes at this stage is, of course, dependent on his/her own outlook and strategic approach.
However, a recent episode from our The Skinny on Options Data Science series evaluated the effectiveness of collars and may be of interest to traders using (or considering) this structure.
The episode specifically examines two collar indices published by the CBOE and compares their long-term results to a few other simple strategies involving the S&P 500.
The two collar indices published by the CBOE are:
S&P 500 95-110 Collar
S&P 500 Zero-Cost Put Spread Collar
After detailing these two collar indices, the Skinny team compares the long-term success of the CBOE collar strategies against a simple long S&P 500 strategy and a short ATM S&P 500 put strategy. The results of this comparison are shown in the graphic below:
As you can see in the chart above, the long S&P 500 and short ATM S&P 500 put strategies easily outperform the collar strategies over the time frame of the study (2000-present).
Having said that, collars obviously offer downside protection, and therefore provide additional "peace of mind" for investors choosing this approach. The results of this comparison, therefore, help reinforce the notion that "peace of mind" comes with a cost (i.e. reduced returns).
Each and every investor has their own unique risk profile and it's entirely possible that protective collars fit your portfolio. From a volatility standpoint, also keep in mind that the deployment of protective collars may be revealed through increasing OTM put values and decreasing OTM call values.
If you have questions on protective collars, or other trade structures you’ve been considering, feel free to reach out at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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