It’s been well-documented that, in general, investors are risk-averse. This aversion to losses leads many investors to seek “tail protection” strategies. And the most direct way to obtain downside protection is to buy put options.
However, purchasing volatility insurance is expensive, because, historically, realized volatility has been well below the level of volatility implied in the price of options. In other words, there’s a volatility insurance premium.
A popular solution for mitigating this cost is to offset the price of the put by selling call options. This strategy is referred to as a “collar.” A common approach is to create what’s called a zero-cost collar—the premium earned on the call equals the premium paid on the put.
Investors will typically view zero-cost equity collar strategies as a way to give up some potential for gains in return for reducing potential losses, without incurring any costs (other than commissions and bid/offer spreads). While that perception may be accurate if one considers only the net dollar cost of the strategy’s option trades, it fails to account for the drag the collar may impose on returns.
Why Collars Can Be A Drag
The first reason to expect a drag on returns is that collar strategies result in having lower exposure to market beta. The second reason is that the cost of purchasing the downside insurance exceeds the return earned by selling an equal amount of upside potential.
Thus, while there may be no upfront expense, if the put option and call option prices are the same, this says absolutely nothing about the investment attractiveness of the trade and its impact on returns.
Roni Israelov and Matthew Klein of AQR Capital Management, authors of the December 2015 study “Risk and Return of Equity Index Collar Strategies,” examined the impact collar strategies can have on returns. Following is a summary of their findings: