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Bad Investment Advice: A “Costless” Collar Strategy

A recent article in Fortune magazine recommended a strategy for protecting your investment portfolio from losses by using option contracts. For investors who want to “insure” their stock portfolio against losses, the author recommended an options strategy called a costless collar. The gist of the strategy is that you buy a put option that will limit your losses if the market declines, while simultaneously selling a call option for an equal amount to pay for the put—making the transaction costless. The rub is that the call option you sell limits your potential gain on the investment you are trying to protect. This strategy is terrible advice. Don’t do it.

What is an Option?

A put option gives you the right to sell a security at a specific price (the strike price) at any time until the option expires. This allows you to limit your potential losses. A call option gives the owner the right to buy a security at a set price until a specific future date. By selling a call option on a security you own, you limit your potential gain, since the person who bought it from you will exercise the option once the security’s price exceeds the option’s strike price.

The Fortune article offers the following as an example: An investor wishes to protect his investment in an S&P 500 index fund. The investor buys a put option that limits his loss to 10% and sells a call option on the same fund that caps his gain at just over 5%. This transaction is referred to as costless since the call option he sold brought in proceeds equal to the cost of the put option he bought. In this example, both of the options had a 6-month term.

When would this strategy pay off for an investor? If the collar is truly a costless transaction, then there would be no impact, positively or negatively, if the market ended the 6-month term between a 10% loss and a 5% gain. If the market gained more than 5%, then this strategy “lost” the investor any investment gain above 5%. And if the market lost more than 10%, then the strategy provides a positive return to the investor. The investor would “gain” any loss beyond 10%.

So why do we believe a costless options collar is bad advice?

  • The transaction might be “cashless,” but the opportunity cost of missed investment gains could be very high (keep reading for details)
  • Outcome is asymmetric—it caps potential gains relatively low, while still exposing you to non-trivial losses.
  • It could result in higher taxes due to short-term capital gains on the options, vs. long-term capital gains/losses on the index.
  • It is complex to implement and provides inexact protection for a globally-diversified portfolio.

Just on the face of it, this seems like a bad deal. As previously mentioned, the payoff to the investor is asymmetric—you only get 5% of the gain, but must absorb up to 10% of any loss. That would be bad enough it your expected return was randomly distributed around zero. But it is not. The market has historically gone up. Hence, your expected return is positive. So just to be clear, this strategy is terrible advice. Please don’t do it.

The Gritty Details

A quick and dirty analysis shows the folly of this advice. First, let’s look at a bit of actual history. How often has the S&P 500 lost more than 10% in a six-month period and how often has it gained more than 5%? The author used the SPDR S&P 500 ETF (Ticker: SPY) in her example. Taking monthly closing values for this security from its inception in 1993 until mid-2013 (source: Yahoo! Finance), I found that in only 10% of the rolling 6-month periods during this 20-year span did the ETF lose more than 10%. Yet in ~47% of the periods the return exceeded 5% (in the remaining periods the return was between -10% and +5%). So about 43% of the time this strategy would have had no impact either way for the investor, ~47% of the time the investor would have lost money following this strategy, and in just 10% of the rolling periods would the investor come out ahead.

Distribution of payoffs for a S&P500 costless collar strategy

“Yeah, maybe,” you say…but what about the magnitude of the losses avoided? If you could protect yourself from a few big losses and only give up a little gain each time, is it maybe still a good strategy? It’s true. If you could avoid big losses and still take advantage of the upside, it could be a viable strategy even if it costs you a little bit of money most of the time.

Alas, the magnitude of the payoff works against the investor in this strategy as well. Using the same rolling monthly data, I found the average forgone gain was 8.1% (for periods when the 6-month gain exceeded 5%). Whereas the average avoided loss was 9.8% during down periods (the 6-month period with a loss greater than 10%).

The end result of employing this strategy is that nearly half of the time you sacrifice an 8% gain for the “benefit” of avoiding an additional 9.8% loss in 10% of the rolling 6-month periods. Clearly this is a bad outcome for the investor! It’s hard to understand why Fortune magazine would promote this as a good strategy for long-term investment success.

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