That is why the strategy is called a collar: The range of returns is meant to be “collared” with limited downside but also limited upside.

Risks

The first risk is the most obvious one: that a collar strategy has sold off its upside potential. This is more of an “opportunity cost,” where gains beyond a certain point are forgone. However, there are additional risks to a collar. As always, the devil’s in the details.

Paying the Price for Puts

One risk has to do with what’s known as the skew of option pricing. In layman’s terms, skew refers to the fact that the prices of put options are usually significantly higher than the price of call options. If a collar strategy is buying high-priced put options and hoping to offset the cost by selling low-priced call options, the collar might not be generating premium to fully pay for the put.

This leaves the portfolio manager with some difficult choices.

  • The P.M. might accept that the cost of maintaining the put might not be fully offset by the short calls. In such a case, the gap between the income generated off the call and cost of the hedge will be an enduring drag on the portfolio performance.
  • The P.M. might seek to offset the cost of the put by selling multiple calls. For every put owned they might sell two, three, four or more calls to generate enough premium to pay for the put. This creates a leveraged bet, and if the market goes past the call strike, this approach can get very painful very quickly.
  • The P.M. might seek to buy or purchase cheaper puts by moving the protection further out-of-the-money. While the cost of the hedge would be reduced, so would the degree of protection. Essentially, the investor would be on the hook for a larger tranche of losses before the protection kicked in.

Potentially Expensive Protection during Bear Markets

The other major risk to a collar strategy is the cost of maintaining it through a prolonged bear market. When collars are established, the protection is usually short-term in nature with the puts going out three months or so. Sometimes more, sometimes less, but three months is typical.

What happens to a collar strategy during an extended market downturn after its initial hedge is cashed in? If the collar is to be maintained, new put options will need to be purchased. But in a protracted bear market like the dot-com crash (2000–02) or the Global Financial Crisis (2007–09), buying new puts every quarter can become prohibitively expensive. The price for short-term protection skyrocketed in such environments and, in some cases, maintaining a collar might be impossible thus leaving the underlying unprotected from downside risk.

Role Within a Portfolio

There is no “silver bullet” strategy that works well in every situation. Every strategy has environments it works well or works poorly. Collar strategies tend to work best in either modestly upward markets or short-term, minor corrections of 5%-10%.

In the case of the former, the collar will enjoy modest gains without too much upside called away. With the latter, the short-term put offers some protection, and hopefully the sell-off isn’t too steep or too prolonged. A case can be made for having a portion of one’s portfolio in such a strategy.

However, if one expects to capture most of the upside in a strong bull market or if one is looking for bear market protection, a collar is not likely to be the best fit.

How Do Collar Strategies Compare to the Defined Risk Strategy?

The Defined Risk Strategy shares a few similarities with collars, in the sense that it has a core, buy-and-hold, long position and purchases options to protect on the downside. However, there are some key differences between these two strategies.

Where the collar has short-term puts, the DRS has long-term downside protection on the equity with a LEAPS put option. With a LEAPS put option, if and when we’re in the midst of a bear market, the DRS won’t be forced to purchase expensive puts for short-term protection or, as would be the worst case for the collar strategy, be left without protection.

Another difference is in the way they generate income. While the collar strategy seeks to generate income by writing calls, the DRS does so via the simultaneous sale of both calls and puts in a market-neutral fashion. This provides the potential for more premium and better opportunity to offset the cost of the put option.

All this leads to a very different return and risk profile than collar strategies: The DRS may provide better protection in down markets with more opportunity for upside potential.

Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.