A Portfolio of Collars
Last Updated
October 16, 2024
Created by Andres Talero
Overview
This article discusses collars and their use as portfolio management tools. General and key pricing aspects of the strategy are presented. Strike selection, skews, strategic positioning, and rebalancing are then discussed. Later sections overview comparative characteristics relative to covered calls, call spreads and bond positions. The final section summarizes portfolio level considerations.
General Aspects
A collar position consists of (i) a long position in a stock or other underlying (ii) a long position in a low strike put, and (iii) a short position on a call with a strike above the put strike. The underlying and options in a collar have a one-to-one ratio (same units for underlying, puts, and calls). Both options share the same expiration.
The main characteristic of a collar strategy is to define a range of minimum and maximum payouts for the aggregate position. Collars are volatility reducing strategies for funded portfolios, provide precise risk definition, and allow flexibility in payout and market positioning.
Compared to holding an underlying on a naked basis, adding a put creates a floor to the payout. Absent any rebalancing, at expiration the minimum payout consists of exercising the put and delivering the underlying. The strike of the call determines a maximum payout. If at expiration the underlying is trading above the call strike, it is called away at the strike price.
Uses of Collars
The most obvious use of collars is as volatility reduction tools. The strategy allows investors with low risk tolerance to preserve exposure to volatile underlyings, while controlling the inherent risks. The strategy also has a place in optimization of risk reward of unlevered portfolios, and in gamma positioning. Risk reward can be manipulated with strike selection and by capturing option premium skews. Gamma can be optimized via strike selection and rebalancing.The main drawbacks of collars are the capped payouts and a need to periodically rebalance.
Pricing Features of Collars
Impact of the call and its premium
Incorporating a short call on top of a long underlying sets a maximum payout for collars. Other characteristics generated by the call inclusion are:
1) The call premium helps finance the put premium. The premium received from selling the call offsets (in whole or in part) the premium paid for the put.
2) The call premium can be set to generate positive net premium. The call strike can be chosen to have a value higher than the put premium - and be used to control the overall carry (net time value) of the combined strategy. At a portfolio level a large net negative premium is undesirable and may create a drag on performance.
3) The call and its premium dampen volatility of the strategy. When the underlying changes in value the short call (as well as the long put) change in value in the opposite direction. Volatility can be manipulated by strike selection. Lower call strikes further offset moves in the underlying.
4) The call time value creates negative gamma. The time value component of the call depreciates slowly through time. It has low sensitivity when the underlying price drops away from the strike. When the underlying price rises out of the money calls can appreciate quickly. For low strike calls (in the money), when the underlying price drops the time value of money increases, offsetting the drop in intrinsic value.
Call strike positioning: Out of the money, at the money and in the money
The premium of high call strikes - those located out of the money - partially or completely offsets the put premium (which is usually set out of the money). High call strikes leave room for appreciation of the underlying prior to expiration. The tradeoffs are a lower upfront premium, and negative short-term gamma for the strategy upon quick appreciation of the underlying.
At the money call strikes maximize premium time value and create a high positive carry position.
Low call strikes result in conservative strategies, with a cushion from downward moves in the underlying. Bond like positions can be created using deep in the money call strikes. Attractive payouts can be created if the underlying is highly volatile.
Put strike positioning
Put strikes for collars are set below call strikes, and usually below the underlying price and out of the money. Put strikes can be selected following risk restrictions, views on the expected performance of the underlying, or to capture other individual characteristics being used in portfolio construction. The long puts position add positive gamma to collars, counterbalancing the negative gamma created by the short position in calls.
The use of puts for risk management has some advantages over managing risk based on a set of expected volatilities and correlations. It sets an exact limit (not subject to estimation error) to the maximum downside of both individual and aggregate positions, makes the cost of risk to a given horizon explicit and improves portfolio convexity in market selloffs.
The choice of put strike presents three important considerations:
1) The put strike sets maximum losses at expiration. For a portfolio of collars, the maximum portfolio loss at expiration can be calculated by comparing the current value of the portfolio with the sum of each underlying times the corresponding put strike.
2) Put strike selection determines the premium of the put, which considered on its own adds a cost to the overall position. For a given expiration, higher strikes command higher premiums.
3) The choice of put strikes sets an initial marginal cost per unit of risk. Strikes can be selected following portfolio level risk requirements, based on utility criteria (an arbitrary preference) or based on rebalancing characteristics (seeking to determine an optimal gamma point). In a combined strike selection approach, gamma considerations are used to fine tune the selection of a single (and to an extent still arbitrary) portfolio level put strike selection criteria.
Standardizing put strike selection criteria is desirable – as it comes under play when the underlying sells off, contrary to the views driving security selection. A rule-based strike selection criteria also reduces behavioral biases.
Combined put and call considerations regarding strike selection
In a collar put and call premiums offset each other, so the absolute value of individual option premiums is secondary to the relative value of the two options.
Positioning Relative to the at the money forward strike
The forward price for an underlying or stock is given by the strike at which puts and calls converge to the same premium. At such price a costless long position in the underlying can be established by selling a put and buying a call with the same expiration. At the same strike a long put and short call create a short with no net premium. Forward prices capture net financing conditions for an asset – such as general market interest rates and income from dividends.
Collars range of potential payouts is determined by the distance between put and call strikes. Choosing considerably out of the money strikes for both puts and calls will set a wide range payout. A wide range can be used when the motivation for adding collars is to eliminate tail losses while avoiding negative carry.
A more constrained portfolio can set option strikes closer to the current value of the underlying, limiting risk to a tighter range. A small range can be set up when there is low risk tolerance.
Choosing a range around high strikes (such as an out of the money call and an at the money put) biases positions for better performance when the underlying appreciates. Lower strikes can be used to create a conservative stance. Selling at the money calls and buying out of the money puts creates a bias for positive net premium and carry, and for positive gamma in a sell off, at the cost of little appreciation potential beyond the time value of the option.
Skews
Price skews denote materially different high and low strike option time values. Relative premiums for high and low strikes are an important factor in strike selection.
Observing Skews
The strike and premium at which puts and calls converge (the forward at the money strike) is directly observable in option chains and can be used as a baseline for observing price skews. At the money premiums can be used as a distance measuring unit – providing a direct and observable link between option implied volatility and skew measuring.
Premiums for strikes one at the money premium away up and one at the money premium away down from the forward can be compared. If there is little price skew the premium of high strike skews will be similar to the premium of similarly distanced to the forward low strike puts. A large price skew is easily observable with this method.
Options on volatile underlyings are usually skewed towards higher relative premiums for high strikes. Purchasing of a put at a given distance from the at the money forward can usually be financed by the sale of a call with a strike further away from the at the money forward, creating an asymmetry in risk reward (higher potential upside than downside).
Index options are usually skewed towards low strikes commanding high relative premiums. As a result, index collars have poor risk reward. To finance the purchase of a put at a given distance from the at the money forward requires the sale of a call with a strike closer to the at the money forward, yielding less upside than downside.
Expiration Choice
Available expirations for liquid listed options are concentrated in the first two to three years sector, constraining expiration choices. Investor horizon and preferences partially drive the choice of expiration. Other factors affecting expiration choice include:
(1) Income oriented strategies are sometimes set with relative short-term expirations, as the premium captured is higher on an annualized basis. Relative to each other, at the money option premiums for different expirations are related by the square root of time.
(2) Rebalancing frequency is directly related to expiration choice. Short term expirations require frequent rebalancing, and an active portfolio management stance.
(3) Price skews are more marked in long term options and during high volatility periods, creating risk reward opportunities.
(4) Interest rate positioning can be a factor in expiration choice. Collars partially lock in interest rate levels, which flow into breakeven of put and call positions via forward prices and as a result of put call parity.
(5) The tax cycle of taxable investments also plays a role in expiration choice. Positions expiring in future years offer more flexibility than short term positions.
Rebalancing
Collar Positions can be set with no intermediate rebalancing to the shortest of a given horizon or the expiration date. As an alternative, periodic and even very frequent rebalancing (to monetize gamma) may be incorporated.
Motivations for rebalancing:
Change in investment thesis. for an underlying or at an overall level – such as a change from high to low volatility regime, or a transition into a new business cycle phase.
Realized moves of the underlying. Marked appreciation or depreciation. Rebalancing usually occurs into the same direction as the underlying market move, or into longer expirations (horizontally or diagonally).
Underlying appreciation. In the money calls may have no time value left. Puts struck too far away from current levels may become ineffective or reach rebalancing criteria.
Underlying depreciation. Puts initially set out of the money may substantially appreciate. Put premium appreciation can be monetized by selling the puts and purchasing lower strike puts. Out of the money calls may lose most of their time value. Rebalancing calls into lower strikes reduces appreciation potential and may lock in losses.
Capture of gamma on the put leg of the strategy. Put rebalancing allows the monetization of gamma, generating income when rebalanced to lower strikes and reducing risk when rebalancing to higher strikes.
Marked changes in volatility. Reductions may allow put rebalancing into higher strikes at a low net premium, or profit taking in short calls. Volatility increases can prompt increasing payout ranges by rolling positions into longer expirations.
Passage of time causing time decay in the options. May result in either horizontal or diagonal rebalancing into longer expirations, or vertically rebalancing puts into higher strikes of the same expiration.
Rules based rebalancing
Incorporating portfolio level rebalancing rules reduces the need for constantly forming opinions on a large set of underlying assets and strikes. It also facilitates consistent decision making and reduces behavioral biases.
Creating rebalancing rules for the puts component of a collar is usually more straightforward than for the calls. Put strikes are selected contrary to directional views and motivated by risk management considerations. Call strikes are set in the direction of the underlying which is usually expected to appreciate.
Setting strike selection criteria facilitates formulating rebalancing rules, and if desired automation. Target strikes based on marginal rebalancing costs can be selected either with a utility-based criteria (a somehow arbitrary preference) or with a rebalancing focus (seeking to determine an optimal gamma point).
The change in premium over the vertical change in strikes of options (strike delta) can be used to calculate marginal rebalancing economics. As put strikes move out of the money, premiums decrease, and the strike delta also decreases. Uniform criteria using a single parameter is relatively simple to implement. Open orders can be used to reduce monitoring requirements.
Example of Rules: The upward strike delta of puts reaching 20% may trigger puts to be rebalanced (using cash and reducing risk). A related rule can be set downward rebalancing for puts if the net premium received when rebalancing reaches 40% of the difference in strikes (generating cash and increasing risk).
Call strike choice usually requires further considerations.
Upward strike positioning is directly connected to views on a given underlying, and call rebalancing may require incorporating additional considerations – so the marginal cost approach used for puts may be insufficient. For example, volatile underlying low strike calls (deep in the money) may be used to extract value from relatively distant risk - without a strong view on the appreciation potential for the underlying.
Highly skewed and momentum stocks present attractive risk rewards – as high strikes can be relatively expensive, favoring the sale of high strike calls. Portfolios can also be set up to harvest volatility premium, favoring sale of at the money calls.
Similarities with fixed income portfolios
The low bound value of a collar portfolio is closely linked to a bond maturing on the expiration date of the options in the collar. Absent rebalancing, and net of premiums, the hedged component of the portfolio will behave as a zero-coupon bond maturing on the expiration date.
Interest rates determine option forward prices – and partially flow through the performance of a collar portfolio via the relative prices of puts and calls. Deep in the money collars mostly behave as bonds – and can provide an alternative to bonds in portfolio construction.
Similarities with call spreads
Payouts of collars and call spreads are symmetric. Break-evens of the two strategies differ because of funding considerations. Collars are a fully funded strategy, with reduced leverage - while call spreads are a levered strategy, with no direct purchase of the underlying.
Because it is fully funded, a collar portfolio contains reserve capital which can be used to rebalance the portfolio, while a call spread portfolio can experience a sudden loss of all the capital in the portfolio.
Collars compared to covered calls
Covered calls are a popular income-oriented strategy consisting of (i) a long position in an underlying and (ii) a short call position for the same number of underlying units. Covered calls are income generation strategies, sometimes also used for volatility reduction.
Covered calls produce higher initial net premiums than collars– as there is no put premium offsetting the premium of the call. Comparatively, covered calls are usually used to collect premium, while collars are used to tightly control risk, as well as directional gamma and skew positioning.
An important drawback of covered calls is asymmetric risk/reward. Potential losses can be much larger than potential gains. Including a put to create a collar improves the risk reward of the strategy - but forgoes premium.
Covered calls do not isolate skews, an important feature of collars risk reward optimization.
Portfolio Considerations
Collars are a versatile volatility reduction strategy. Portfolio level motivations for using collars include:
(1) Setting a maximum shortfall for individual positions and at a portfolio level, via the purchase of puts for each individual position.
(2) Creating a portfolio with appreciation potential and controlled risk.
(3) Creating a net positive premium – positive carry portfolio – achieved by selecting calls with higher premiums than those of puts.
(4) Price Skew isolation for high volatility, momentum stocks and otherwise skewed to the upside option functions. Can create positive convexity positions (more upside than downside), or attractive risk rewards for deep in the money positions.
(5) Isolation of optimal strikes according to portfolio high level criteria – of use for dynamic portfolio optimization strategies or as risk management tools. If desired capital deployment into risk can also be made homogeneous by setting the same marginal cost of puts for all the underlying assets in a portfolio.
(6) Gamma efficiency - Income can be generated from dynamic rebalancing of the put leg of the strategy – adding value in frequently rebalanced portfolios. At a portfolio level cash generation is maximized when the portfolio decreases in value.
(7) Improve the risk reward vs covered call income-oriented strategies – which have asymmetric risk reward, as potential losses can exceed appreciation potential.
(8) Expand the suitable underlying universe for conservative portfolios. Allow the inclusion of otherwise unsuitable underlying assets by controlling payout volatility. Some of such assets may have attractive correlation features, and premium skew is usually high for volatile underlyings.
(9) Improve portfolio long term growth rates by reducing volatility drag. The same average return per period compounds into a lower cumulative rate as volatility increases, so other things equal, reducing volatility on its own has a positive impact on cumulative growth rates.