Collars Keep A Tight Rein on ETFs

In a market expected to decline, an investor can use options as insurance to protect a portfolio. Usually this means buying puts, but another less expensive strategy is to buy a protective collar.

A collar is a combination option position consisting of a short call, a long put and an existing or new position in the ETF. Both options have the same expiration. An investor buys a put with a strike price below the current price of the ETF and sells a call with a strike price above the current price of the ETF. The income from the call helps pay for the cost of the put, thus reducing the cost of the strategy or even eliminating it. The collar derives its name from its constraint of both losses and profits.

The collar normally starts with a long position in shares of an ETF. If the price of the ETF runs up above the strike price of the call, then the seller of the call will be assigned, that is, will be required to sell shares in the ETF at the strike price of the option contract. If the investor already owns the ETF in question, these can be offered to satisfy the requirement. Otherwise, an investor would have to go to the market and purchase shares to sell at an immediate loss. Most brokerages will not allow investors to sell calls unless they have sufficient shares in the ETF already or have other funds in reserve.

When the profit and loss from a collar position is charted against the price of the ETF, the loss limit and profit limit are easy to see. A general picture of a collar is below.

To illustrate the protective properties of the collar, we selected a position in the DIAMONDS TRUST (AMEX:DIA) options expiring in April '04. To illustrate the limitations of the collar, we will compare it to the simpler protection scheme of buying a put.

First we select the collar on a portfolio with 1000 shares of DIA. The price of DIA was $100.29 at the time we set up the position. The put with strike price of $99.00 was trading at $1.20 and the call with strike price of $101.00 was trading at $1.35. Since the put is a purchase and the call a sale, then the insurance will be established at a credit, meaning that we will make fifteen cents on each option. Since each option contract covers 100 shares, we will buy 10 contracts of the put, and 10 contracts of the call. The puts will cost $1.20*100*10=$1,200.00, but the calls will be sold at $1.35*100*10=$1,350.00. The position will earn a credit of $150.00!

In the tables below we list the profit and loss for the position over a $10 range of prices for DIA. Be aware that should the price go above the strike price of $101.00, an American call option may be assigned before the expiration date for the option. Also, the calculations do not in any way account for transaction costs or tax effects.

Initial assumptions:

Results based on scenarios:

The first row of the second table shows a range of prices centered at $100.00, which is near the price of DIA at the time of the trade. These prices represent a range of possible prices where DIA could close at expiration. The second row of the table shows the expiration value of the April put at each of these possible prices, and the third row shows the value of the call. The bottom row shows the value of the portfolio, including the loss on the shares as the price declines from $100.00. For the sample position of options hedging 1000 shares, the maximum loss will be $1140.00. Conversely, the maximum profit on the 1000 shares with the collar will be $860.00. By contrast, a DIA position purchased at $100.29 a share without any option protection would have lost $5290.00 if the price decreased to $95.00. Should the price go higher than the $101.00 strike price on the call, the shares will have to be sold to cover the assignment.

Now compare the portfolio with a collar to a portfolio with protective puts. The graph below shows the profit and loss diagram of this collar next to the profit and loss diagram for a position hedged with a put only. The put has a $100.00 strike price and costs $1.50 per contract. The total cost of the put only hedge is $1,500.00. The downside protection from the collar in this example is better than that of the puts, but the upside is drastically limited.

Changes in the strike prices for the options in the collar will change the effectiveness and cost of the collar. Notice how quickly the upside potential is capped with the sample collar. Choosing a call with a higher strike price will relieve that pressure but will also reduce the income from the sale of the call. Choosing a put with a lower strike price will reduce the cost of the put, but, should the market tumble, the position would sustain higher losses. The investor should consider these trade-offs when trading into a complex position such as a collar.