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:
- A collar has lower equity beta than the underlying equities and thus earns less equity risk premium. Regardless of whether the options are cheap or expensive, buying a put option reduces the portfolio’s equity exposure, as does selling a call option.
- Because investors are risk-averse, equity options tend to be expensive. With collars, the out-of-the-money put options purchased tend to be more expensive than the out-of-the-money call options sold. Thus, a collar should be expected to hurt performance on a risk-adjusted basis.
- While there is a netting of volatility exposures from the put and call options, the strategy incurs a cost because the put option carries a higher-volatility premium. In the case of a zero-cost collar, the put option’s negative alpha should dominate. In other words, while volatility is reduced, it comes at cost in terms of lower returns—even if the explicit costs are zero.
- Investing in a typical equity collar has provided lower returns and a smaller Sharpe ratio than investing directly in the S&P 500 Index. In other words, collars generate significant negative alphas.
The authors concluded: “An investor is better off simply reducing her equity exposure.” But that said, there may be reasons to consider using a collar to delay the timing of a sale.
The first reason is to reduce the risks of owning equity (through the collar’s property of reducing exposure to market beta) while an investor waits on a holding period to allow for long-term capital gains treatment.
The second reason is similar. A collar could be used to delay a sale in anticipation of death so that heirs could obtain a step-up in basis, avoiding capital gains taxes.
Volatility Strategies Can Work
There’s one other conclusion that can be drawn from the authors’ findings. Given that realized volatility has been less than implied volatility, a strategy that shorts volatility should earn positive returns. An interesting idea, then, is to not only sell the “expensive” puts (thus earning a volatility premium) but to simultaneously sell calls (earning a second volatility premium).
Selling volatility provides a diversification benefit (all the different index options earn the volatility risk premium) but, again, due to diversification, selling a basket of options is preferred to selling a single option. And this strategy allows you to earn the return on the collateral while also earning two volatility premiums. In addition, you have the knowledge that, ex-post, you cannot lose on both.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.