A collar is an options strategy implemented to reduce a fund’s volatility and provide a measure of downside protection.
“It minimizes your drawdown potential, while also minimizing your upside potential. For some investors, that feels better than just de-risking the old fashioned way — by selling,” Dave Nadig, director of research and CIO at ETF Trends, said.
There are generally two components to an options collar strategy: selling call options to generate premium, and simultaneously reinvesting some of that premium to buy put options on the same reference assets to mitigate the downside risk that coincides with owning equity securities.
“The point of a collar is to minimize the range of possible outcomes by selling away a bit of your upside in order to buy a bit of protection on the downside,” Nadig said. “This is the investing equivalent of putting up the inflatable bumpers at the pool hall — you know the ball’s going to get down the lane, and you know the entire range in which it could go.”
A written call option gives the seller the obligation to sell shares of the reference asset at a specified price until a specified date.
The writer of the call option receives a premium for writing the option. In the event that the reference asset appreciates above the strike price and the holder exercises the call option, a fund will have to pay the difference between the value of the reference asset and the strike price or deliver the reference asset (with the loss being offset by the premium initially received), and in the event that the reference asset declines in value, the call option may end up worthless, and the fund retains the premium.
The call options written by a fund are collateralized by the fund’s equity holdings at the time the fund sells the options.
When a fund purchases a put option, it pays a premium to acquire the right to sell shares of a reference asset at a strike price until the expiration date.
In the event that the reference asset declines in value below the strike price and a fund exercises its put option, the fund will be entitled to receive the difference between the value of the reference asset and the strike price (the gain is offset by the premium originally paid by the fund), and in the event that the reference asset closes above the strike price as of the expiration date, the put option may end up worthless, and the fund’s loss is limited to the amount of premium it paid.
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