Advanced Hedging Strategies

Abstract

Put Hedge Follow-Ups Using Put Spreads to Hedge Collars Conclusions on Protective Option Strategies

Full text

Chapter Seven: Advanced
Hedging Strategies
This chapter will discuss follow-up actions that stem from basic put
hedging and identify strategies that combine call writing with put-buying to take
advantage of the strengths of both techniques. In addition, we discuss the notion of
using combined put-call strategies as a continuous portfolio management approach
for managing volatility and reducing downside risk.
Put Hedge Follow-ups
Until now, we’ve evaluated put hedging from the simple perspective of
what happens at expiration. But, as with other option strategies, a lot can happen
in the interim. While you are not obligated to do anything prior to the expiration of
your put hedge, the chances are good that you will want to, as follow-up action is
frequently called for and may represent opportunities to enhance your success with
the strategy.
The simplest follow-up action is just to close the position by selling the put
or perhaps even selling both the put and the underlying stock or ETF. A common
problem in options is to implement a strategy and then focus so much on the
strategy and potential follow-ups that one loses sight of the underlying position.
For covered call writers, that means losing sight of the fact that the underlying
stock -- not the call option -- contains all the risk in the position. With a put hedge,
it can also mean developing a false sense of security about downside risk. The put
does provide a much more effective hedge than a covered call, but that hedge is
still not 100% effective, and some money is lost when the stock declines. In
addition, the time value in your put represents a cost, and the longer you keep the
hedge on, the longer you incur cost.
The good news is that you can sell the put option at any point you decide to
remove the hedge and either book a profit on your put or at least recover some of
the cost. The underlying stock may move higher, or new information might arise
that causes you to feel you don’t need the put any more. Remember, as we
discussed in Chapter Six, to save on the daily cost of a put hedge, you will
generally want to purchase a longer dated put. That means you are intentionally
purchasing protection for much longer than you need it with the idea that you will
want to recover what you can once the stock moves or the situation changes. If the

stock does go down, you may be presented with an opportunity to book some
profit from the put early.
As discussed in relation to covered call writing, rolling is the act of closing
an option and reopening a different one to replace it. It is generally used to
preserve the integrity of a strategy but change either strike price, duration or both.
Since options all have a limited life, the most obvious need for rolling comes as
your option is expiring and you need to reopen a new one to keep your strategy
intact. Waiting until an option actually expires and then either purchasing or
selling a new one on the following Monday is possible, but frequently undesirable.
If your put hedge is in the money at expiration, for example, the new rules on
automatic exercise will result in your put being exercised and your stock being
sold. If that is not your objective, you must roll that put option prior to expiration.
In addition, the underlying may move by Monday, presenting you with higher or
lower cost for your new position.
As with covered call writing, deciding how far in advance of expiration to
roll a put hedge is a judgment call that depends on a number of factors including
the option you currently hold (or have written), the one you intend to roll to, and
your expectation of the underlying’s potential movement prior to expiration. If, for
example, you hold a stock that is currently 30 and you’ve had a put hedge on using
the 25 strike price, your put is about to expire five points out of the money and is
worth next to nothing. It still provides you with protection, but will hardly budge
in price, even if the stock were to drop 2-3 points immediately. If your intention is
to purchase another put at 25 or 30 in a more distant month when this one expires,
then the price of the new put is what you need to focus on, since movement in the
stock of even a point or two will affect the price on the new puts you intend to
purchase. Your decision therefore rests entirely on the expected movement in the
stock prior to expiration, as that is what will most affect the cost of purchasing the
new puts.
On the other hand, if the stock is 30 and you have a 30 strike put hedge
expiring, it will still carry value and still move up and down with the stock. Time,
in addition to price is a factor in your decision now. The sooner you can swap into
a longer-dated replacement, the better off you’ll be in terms of diminishing time
value on the current put hedge. (Taken to the extreme, if you are trying to establish
a continuous put hedge and thus purchasing a very long dated put to reduce the
daily cost of time value decay, you might buy a LEAPS option with more than a
year until expiration and roll it into another LEAPS option when it gets down to
say six months in order to preserve the slow rate of time decay.)
As with covered writing, the optimum time to roll a put hedge prior to
expiration is a guessing game as it depends largely on the movement of the
underlying stock. This should not, however, detract from the merits of the strategy,
and does not represent any more of a guessing game than when to buy or sell the

stock, or when to implement a put hedge in the first place. The reason for buying a
put hedge at all is for protection from unknown circumstances, and those
circumstances are just as unknown when buying a stock as when rolling a put
hedge.
In reality, put hedges are more likely to be rolled or closed well prior to
expiration anyway. There are several reasons for this. First, since put hedging
represents a cost, and since the cost of an option in terms of time decay is most
acute as it approaches expiration, holding a put hedge until expiration is usually
not optimal. Second, since put hedges are most frequently initiated for a limited
purpose, fear or anticipation, they are often closed once the situation changes.
Third, with put hedges, a significant move in either direction will present
opportunities to roll the option prior to expiration. To illustrate what happens in
both the up and down scenario we will use the example in Table 7-1 below.
Table 7-1 Put Hedge Follow-up Scenarios
Source: CBOE Calculator
Follow-up action for an up move
We begin by assuming XYZ stock is 60 and we have purchased a 90-day
put hedge on XYZ at the 60 strike for 2.94. The first scenario is one in which the
stock rises by 10% during the next 30 days. In this scenario, the put loses 2.35 of
value, but the stock has gained 6.00 of value, so the net position has gained in
value by 3.65. Overall, this is a positive result though an investor will likely
experience some regret at having purchased the put hedge in this situation. The
new scenario leaves the investor with a number of follow-up choices:
Initial Put Hedge Stock up 10%
after 30 days
Stock down 10%
after 30 days
XYZ = 60 XYZ = 66 XYZ = 54
Put strike = 60 Put strike = 60 Put strike = 60
Put price = 2.94 Put price = .59 Put price = 6.41
Duration = 90 days Duration = 60 days Duration = 60 days
Volatility = 25% Volatility = 25% Volatility = 25%
Interest rate = .5% Interest rate = .5% Interest rate = .5%

1. Do nothing. The original parameters would remain intact and the investor
would continue to be protected below 60 at a cost of roughly 5% for the
three months (2.94/60). But the stock is 10% higher now and still only
protected below 60, so there is an added exposure that is not protected by
the current put.
2. Close the put. If the situation has changed sufficiently and no longer
justifies the need for a put hedge, then the put can be sold for .59.
Additionally, the stock itself could be considered for sale at this point as
well.
3. Roll up. If there is still a concern about downside risk, and the stockowner
wants to protect the recent appreciation in the stock, they could roll up to
say a 65 or 70 put, either in the same month, or for a new, longer duration.
The new put would involve additional cost and should be evaluated on its
own merits.
4. Sell a covered call. The rise in the stock now presents an opportunity to sell
a covered call at say 65 or 70 to help protect some of the appreciated value.
The original put could be kept or sold, and the proceeds of the call can be
pocketed or used to roll the put up to a higher strike.
Follow-up action for a down move
Now let’s consider the scenario where the stock goes down 10% instead. A
month later, the stock is at 54 and the put is now at 6.41. (In this example, we have
assumed volatility to be the same, but with a drop of 10%, it is likely that the
implied volatility on the options would actually rise somewhat, expanding the
prices of most options on this stock in the near month expirations.) In this
scenario, you will have done well by protecting your position, and though your
stock declined by 6 points, your put gained 3.49. Overall, your net position has
thus lost 2.51 in value, but you would probably be gratified that you had the good
sense to have hedged your position. Here too, you can opt to do nothing and
maintain the original position, but at least two other choices will now have
surfaced that can alter your risk/reward by lowering the break-even on the original
position.
1. Do nothing. Your put hedge has worked well, and because it is now in
the money, its high delta (-.84) will provide a substantial degree of
protection on any further decline in stock value. You would not,

however, participate much in any bounce-back in price from here on the
stock until it got back up through 60.
2. Close the put and book the gain (6.41 credit). If you believe your put
hedge has served its purpose and the decline in the stock is largely over,
you would now have the ability to sell the put and lock in its gain.
While you would no longer be protected against further decline on the
stock position, you will have booked a gain of 3.47 (6.41-2.94) and, by
doing so, lowered your break-even on the underlying position by that
amount. Plus, you get back your initial cost on the put as well --
something that you would lose if the stock closes anywhere above 60 at
expiration. So, unless you feel that the stock still has downside risk, this
can be an advantageous move. (There of course is no magic about
closing at the 30-day mark. You would do it whenever you felt confident
that the stock was largely finished with its decline.)
We view this as the rough equivalent of walking away from the
blackjack table while you are ahead. If you stay at the table, you might
continue to be lucky, but the odds are against you. If you remain in the
put, you would stand to gain more if your stock continues to decline, but
time is against you, and if the stock bounces back (something more
likely to happen with stocks than in blackjack), you will not participate
much in that rise. Remember, even if the stock moves all the way back
up to 60 at expiration, you will still have paid 2.94 for protection
(almost 5%) and would have nothing to show for it. By cashing out the
put now, you got back the cost of the insurance plus a tidy profit that
can now sit in the bank. If you have further trepidations about the stock,
the next two alternatives offer ways to continue with some protection.
Figure 7-1 illustrates the modified risk/reward achieved by closing the
put hedge under these conditions. You can see how you would now have
downside risk again, but would profit in all cases where the stock rises
from here.
Figure 7-1 Holding vs. Closing a Put Hedge
[OVM 7-1.AI]
3. Roll the 60 put to the 55 put (3.70 credit). If you would like to book

some of the gain from the put thus far, but keep a hedge on against
further decline, rolling down is a compromise you can now consider. To
do that, you would sell the 60 strike put and purchase the 55 strike put,
taking in $3.70 in the process. You can do it all in one transaction if you
enter it as a spread order (Sell 60 put/Buy 55 put at 3.70 credit) or you
can close the current one first and then buy the new one. The roll-down
keeps the stock protected while booking some profit from the original.
As with closing the put hedge altogether, the credit received lowers your
breakeven and enables you to begin participating in gains on the stock at
a lower price if it should rise.
The tradeoff is that you will have swapped your option for one with
more time value (1.72 vs. .41) and a lower delta (-.55 vs. -.84), so if the
stock does decline further, you are not protected quite as much as with
your original put hedge.
Figure 7-2 Holding vs. Rolling Down
[OVM 7-2.AI]
4. Sell the 55 put to create a spread (2.73 credit). There is another follow-
up action that enables you to maintain your original 60 strike put hedge.
Instead of rolling down to the 55 put where you would be protecting
your stock price from 55 down to zero, you can keep the protection
starting at 60, but cut it off at 55. You would do this by keeping the 60
put and now selling an additional 55 put, thereby creating a 60/55 bear
put spread. Like the two strategies above, creating the spread takes in a
credit that lowers your breakeven. You have changed the risk/reward
parameters, this time re-introducing downside risk below 55. This is still
less risk than holding the stock, though, because you are protected
between 60 and 55.
Figure 7-3 Holding vs. Creating a Spread
[OVM 7-3.AI]

Using Put Spreads to Hedge
In the example above, we turned a basic put hedge into a put-spread hedge
when presented with a drop in stock price. There is nothing, however, that
prevents you from using a put-spread hedge when initiating your hedge in the first
place.
The appeal and effectiveness of put hedging has always been dampened by
the attendant cost. Consequently, put hedges are generally used on occasions when
it is determined that downside risk is substantial or short-lived enough to justify it.
For long term portfolio management, the cost of straight put purchase is simply
too prohibitive to become a standard practice. To summarily dismiss the idea of
using put hedges because of cost, however, would be misguided, since they are
still a valuable tool for protecting against significant downside risk, and since
there are ways to mitigate the cost by modifying the strategy. One way to do that is
to utilize put spreads to create the hedge.
The bear put spread (purchase of a put and simultaneous sale of another put
in the same expiration month at a lower strike price) will always cost less than the
put purchase by itself, and makes intuitive sense as a hedging mechanism because
it enables the hedger to select the exact range in stock price to protect. A straight
put purchase will always protect the underlying stock from the strike price all the
way to zero. You pay for that degree of protection, but is it always necessary? Are
you really concerned your stock might go completely to zero, or are you more
realistically concerned with cyclical selloffs of say 10-20%?
We already discussed how you probably save on your car insurance by
accepting a deductible, and showed how buying a put hedge at a strike price below
the stock’s current value accomplishes that same effect on a put hedge. Using a
put spread to create the hedge instead of a long put by itself serves the same
purpose, but instead of saving money by ignoring the first 10-20% of downside
risk and protecting the remaining 80%, you save money by protecting the first
20% and ignoring the last 80%. (These numbers are only approximations to
explain the point. In reality, you would use different strike prices to determine
exactly how much risk you want to protect and how much you’re willing to
absorb.)
Figure 7-4 illustrates the difference between the amount of protection
gained from a basic put hedge at a strike below the current price vs. a put spread.
The basic put hedge protects from the selected strike all the way to zero, whereas
the put spread protects the price range between the strikes of the spread, and that
can be any two strikes of your choosing.

Figure 7-4 Basic Put Hedge vs Spread Hedge
[OVM 7-4.AI]
Figure 7-5 Risk/Reward of Basic Put Hedge vs. Spread Hedge
[OVM 7-5.AI]
Debit Put spreads
Say you are long 100 USO (US Oil Fund ETF) at 36 and it is now
December 1st. Table 7-2 shows the cost and amount of protection for a long April
put and several debit spread alternatives using the same long put and selling one of
several alternative strikes in the same expiration to complete the spread. The
straight purchase of a 36 strike put would protect all the way to zero, but would
cost $282 per 100 shares of stock – nearly 21% of the stock’s value on an
annualized basis. You could hedge, on the other hand, a decline to 30 for only
$200, or a decline to 32 for $154 – almost half the cost of the original put by itself.
Table 7-2 Costs for Put Spreads on USO
Type Cost Annualized % Amount of
protection*
Long April 36 put Long put 2.82 20.9% 100%
Long April 36 put
Short April 30 put
Debit
spread
2.00 14.8% 16.8%
Long April 36 put
Short April 32 put
Debit
spread
1.54 11.4% 11.2%
Long April 36 put
Short April 34 put
Debit
spread
.88 6.5% 5.6%
Source: www.poweropt.com *excluding the cost of
the put

The put spread protects only a specified amount of the potential loss on the
stock and costs less to implement accordingly. If you hedge, as in the above
example, using a 36/30 debit put spread, then you only hedge a decline to 30.
Below that, you are unhedged. But that may be a worthwhile tradeoff in that it
costs 2.00 instead of 2.80 – a savings of nearly 30%.
Beyond the fact that your protection is limited, there are other tradeoffs
with spreads. If the stock declines, the value of the spread will theoretically widen,
but not as much as the value of a single put by itself would rise. In other words,
the spread has a lower delta than a long put by itself, making it less efficient if a
sharp down move occurs, especially when there is still a lot of time before
expiration.
In addition, there are practical matters concerning execution. Theoretically,
a put spread will reach its full theoretical value (6 points in the above case) if the
stock price drops below the lower spread strike at expiration. But in reality, the
holder should always expect to lose a little on each side of the trade from bid-ask
differential, not to mention transaction costs. The amount one gives up to market
makers to close a spread might only be $.05-$.10 per option if the option is liquid,
but could be as high as $.30-$.40 in a much less liquid option series.
Thus, even if the stock in the above example were to trade below 30, the
holder of the put spread should expect to net something less than the full strike-to
strike theoretical value of the spread. As an example, if the stock is 28 at
expiration, the theoretical value of the 36/30 debit spread would be 6. But the
quote for the 36 put might be 7.90 - 8.10 and the quote on the 30 put might be 1.95
- 2.05, yielding only 5.85 if executed at the bid and offer respectively. If the spread
is closed prior to expiration, the actual closing price will likely be even further
from theoretical value. These prices are shown in Table 7-3.
Table 7-3 Typical Spread Quotes
Option Theoretical price
when stock is 28 at
exp
Bid-ask Actual price to
close position
36 8 7.90 – 8.10 7.9
30 2 1.95 – 2.05 2.05
Net price 6 5.85 - 6.15 5.85 (at bid & offer)
Table 7-4 shows an example of debit spreads of varying duration on a stock
with a price and volatility similar to that of the S&P 500 SPDR ETF. The cost per
share of puts at two strike prices (if purchased) and the net cost of using the two as
a debit put spread instead. It shows that you could theoretically purchase a one-

year put hedge at say 115 for 7.31, or about 5.8%. Given that you would still have
8% downside risk and would have paid almost 6% to have that protection, you are
exposed to about 14% of downside risk and will suffer a 6% drag on upside
performance if the underlying goes up instead of down. As an alternative, the
125/115 spread costs 4.74, or 3.8% and protects from 125 down to 115, so a drop
to 115 would be fully hedged and would only cost 3.8%. The spread, however
would have additional risk below 115, whereas the 115 put by itself would not.
In sum, the debit put spread may provide a cost advantage over a basic put
hedge, but should not be assumed to be a better strategy in all situations.
Table 7-4 Cost of a Debit Put Spread at Various Durations
Stock = 125
Spread = 125/115 debit spread
Volatility = 25%
Interest rate = .5%
Put strike 30 days 90 days 120 days 240 days 360 days
125 3.55 6.11 7.05 9.90 12.05
115 .51 2.20 2.93 5.37 7.31
125/115 3.04 3.91 4.13 4.53 4.74
Put calendar spreads
Part of the problem with using the debit spread to hedge stock is deciding
on duration. A long duration works well for the buy side, since it lowers time
premium per day. But that is not an advantage on the short side of the spread.
When you are short an option, you want to take advantage of the near month
expirations where time value decays fastest. A way to address this issue is to create
a spread where the long side is distant and the short side is close -- and that is the
definition of a calendar spread.
In the calendar, one purchases a somewhat long-dated put, such as a 6-
month or one-year put, and sells a short-dated (one or two-month) put against it at
the same or lower strike price. Because the short put is closer in duration, you
receive less money for it, but you would write another when that one expires and
another after that. That brings in more time value over many months, but also

creates more trades and transaction costs than would be experienced with a single
bear spread in a distant month.
As with other enhanced put hedge strategies, the calendar spread reduces
the cost of the basic long put hedge, but also reintroduces downside risk back into
the equation. The goal is similar to that of using debit spreads to hedge -- that is to
reduce the price of the basic long put hedge, while still providing an acceptable
amount of protection. The short side will expire each month, resulting in multiple
writes on the same long (if the long is a one-year option, then there could be
twelve individual one-month options written against it over the course of the year).
That provides flexibility when rolling the one-month options to move up or down
in strike price, resulting in more time value over the course of the year. As long as
your close-in put is at the same or lower strike, there is no margin required – you
just pay for the long put in full. If the stock declines, you can roll the close-in
option down to prevent assignment. You can hold the long side for as long as it
makes sense, or roll it up or down in strike during the year if movement in the
underlying justifies such action.
The advantage of the put calendar spread as a hedge is that it combines the
annualized cost advantage of a long-dated put option with the quick time decay of
a short-dated option, and gives the put hedger a way to keep a continuous hedge
going at a relatively inexpensive cost. The close in put (short side of the calendar)
can be somewhat discretionary. There may be times when the hedger may not
write anything close in and just keep the basic put hedge going. At other times, a
decline in price on the stock might set up an opportunity like we discussed earlier
in this chapter to implement follow-up actions.
The additional ongoing flexibility of the put calendar spread as a hedge also
means there is more ongoing management. And if the stock drops precipitously in
a given month, the overall hedge may be relatively ineffective at offsetting the
value of the decline if the short put is the same strike as the long. But calendars do
not have to be at the same strike price. By writing the short dated put at a lower
strike price, the put calendar hedge takes on more of the character of a bear spread
and will provide at least some degree of downside protection.
Ratio and Butterfly Spreads
From here, there are still other logical extensions that can be applied to the
basic put hedge in order to further refine the risk/reward of the strategy to a
specific situation.
A ratio spread, for example, could be used instead of a debit put spread to
create the hedge. This would entail buying a basic put hedge and selling not just
another put at a lower strike price, but say two puts at the lower strike price. (Ratio

spreads do not have to be 2:1. Any number of additional puts can be considered a
ratio spread.)
If you had a stock at 60, for example, and purchased a six-month put hedge
at the 55 strike, it would cost about 2.00. The 50 strike put might be around .75.
The debit put spread using these two strikes would therefore cost 1.25 (2.00 less .
75). Selling two of the 55 puts for each 60 put instead would cost only .50 (2.00
less 1.50). The resulting ratio spread would protect the stock between 55 and 50 at
a cost of only .50, but below 50, the hedger would not only be exposed to
downside risk again, he would be exposed to double the amount of it. In other
words, for every dollar the stock ended below 50 at expiration, the hedger would
lose one dollar on the stock plus an additional dollar on the extra put. The
Risk/reward for a 2:1 ratio as described above is illustrated in Figure 7-6.
Figure 7-6 Risk/Reward for Ratio Hedge
[OVM 7-6.AI]
Taken one step further, the hedger could then purchase the 45 put, thus
creating a butterfly spread as the hedge (long one put at 60, short two puts at 55,
and long one put at 45 -- all in the same month.) This would add back in about .20
of cost and would pick up protection again between 45 and zero.
In concept, ratio spreads and butterfly spreads are somewhat inexpensive
and can potentially make a profit many times their cost (though transaction costs
for individual investors can be prohibitive). That might sound like an attractive set
of traits for using as a hedging mechanism. But the ratio spread adds back even
more risk below a given drop in the stock price and the butterfly spread makes its
maximum gain at a specific price (the strike in the middle) and makes less the
further away from that optimal price the stock gets. The idea that anyone could
peg the price of a stock to a specific strike price in six months is so remote that we
see very little use for butterfly spreads in this manner.
Splitting the dierence
To round out all the reasonable possibilities of modifying a basic put hedge
that we could think of, we also want to mention that multiple strikes or durations
can be used in almost any of the situations we’ve mentioned. Even a basic put

hedge does not always have to be all in the same month at the same strike. If you
find yourself wrestling with a decision as to whether you should buy the March or
June put hedge, you can split the difference and buy some of each.
This is particularly useful when there are strike prices in five-point
increments. The 60 strike may seem too close, but the 55 strike seems too far.
Splitting between them can give you the equivalent of a 57.5 strike price, or
splitting your options 6:4 between the 60 and 55 strikes gives you the equivalent
of a 58 strike.
In the ETFs, it is common to have one-point strike increments. This
presents an opportunity to spread your hedge over a number of them. You could
split one-third across three strikes or one-quarter across four strikes. Similarly, you
could do the same with expiration months. A hedge, for example, divided up
among several different expiration months could effectively “ladder” your hedge
across time in the same way a portfolio manager might ladder bonds to mature
throughout the year rather than all at once.
Collars
So far, this chapter has explored a number of ways in which a basic put
hedge can be modified by the sale of other puts to reduce its cost, albeit at the
expense of reducing the amount of downside protection it provides in the process.
An alternate approach to reducing the cost of a put hedge is to sell a call, rather
than another put. The resulting position -- a covered call write combined with a put
hedge on the same underlying stock or ETF -- is a collar. The sale of the call
brings in money to help pay for the cost of the put, and of course the ultimate
protective strategy for any stock investor is the “no-cost” collar, in which the sale
of the call completely pays for the purchase price of the put. This is often possible,
though shouldn’t be held as a consistent objective.
The ability under some circumstances to write a call with enough premium
to virtually offset the entire cost of the put makes this an intuitively appealing
concept, though of course, it means little to have free downside protection if you
completely remove your upside potential as well. In fact, if you were to implement
such a strategy using a put with a strike price at or above the current price of the
stock (to obtain total downside protection), you would find that the call at the
same strike price would effectively guarantee that you will gain absolutely nothing
on your stock position, and in fact lose a small amount of money. (The position
just described is actually an extreme form of collar called a conversion -- a riskless

arbitrage trade popular among professional traders and hedge funds that generates
very small profits at little or no risk, but which is impractical for retail investors.)
The challenge, therefore of implementing an effective collar strategy is
using a put and a call at different strikes and balancing how much downside you
want to protect vs. how much upside you want to give up to pay for it. (Ironically,
this is the very strategy that Bernie Madoff called “split-strike conversions” and
claimed to be employing as he systematically defrauded his investors in the most
infamous ponzi scheme ever perpetrated. The strategy of using split-strike
conversions, or collars, is a perfectly legitimate one, yielding low-volatility, low
risk results -- just not at the consistent double-digit level of annual performance he
claimed every year.
Below, in Table 7-5, are five examples of 90-day collars on hypothetical
stock XYZ. It can be seen from this table that one can tailor the strategy using
different strike prices to offer varying degrees of protection and upside potential
accordingly. For a very low volatility/low risk strategy, one might use a 65/60
collar, risking a maximum of 3.6 % of the investment, but yielding only a 4.5%
maximum gain on the upside. On the other hand, a 70/55 collar allows up to 11.4%
risk, but has the possibility of a 12.6% maximum gain. In both cases, though, the
cost of getting downside protection is pennies, so it is practically free insurance.
Table 7-5 Collars at Different Strikes
XYZ = 62
Duration = 90 days
Volatility = 25%
Interest Rate = .5%
Theoretical put prices:
55 put = .63
60 put = 2.10
65 put = 4.82
Theoretical call prices:
60 call = 4.17
65 call = 1.89
70 call = .72
Call strike/put strike > 60/55
Collar
65/60
Collar
65/55
Collar
70/60
Collar
70/55
Collar
Net outlay for collar 58.46 62.21 60.74 63.38 62.11
Max risk %* 5.9% 3.6% 9.5% 5.3% 11.4%
Max gain %* 2.6% 4.5% 7.0% 10.4% 12.7%
*for the period - not annualized
Source: CBOE calculator
One thing to point out from these numbers (especially for those who are
still wondering about Bernie Madoff’s split-strike conversion claims), is that while
the maximum risk and maximum gain numbers may be skewed in one direction or
the other to accommodate a positive or negative outlook on the underlying stock,
there is no scenario in which the maximum risk is zero, and that the larger the

upside gain potential, generally the larger the downside as well. Therefore, there is
no scenario under which one could assume to generate consistently positive
returns using this strategy.
Figure 7-7 shows the risk/reward of a typical collar. The area within the
upper and lower lines represents the entire profit/loss range for the position. Since
it is so tightly contained, it is easy to see how the collar strategy dramatically
reduces volatility, and the fact that downside is capped at a certain amount means
that the prospect of substantial downside has successfully been eliminated.
Figure 7-7 Risk/Reward of a Collar
[OVM 7-7]
This illustration is for a basic collar, but like the modifications we did to the
basic put hedge or basic covered write, we can apply modifications to the basic
collar as well. One that we tend to favor is the writing of an additional credit call
spread above the collar, particularly when we assess the possibility of a strong
upside move is low. The extra credit spread brings in additional capital, which
enhances returns if the stock languishes or declines. Since the call premium in the
basic collar position is used to defray the cost of the protective put, the benefit of
the premium as income is lost. So, we simply write another one, though we accept
a bit of upside risk for doing so. This upside risk doesn’t come into play until the
strike of the extra call is reached, and by then, the collar has made a profit.
Consequently, the strategy loses that profit back to the extra call if the stock keeps
going higher, but the spread puts a cop on the upside, so the maximum loss from
upside risk usually ends up being very small. Figure 7-8 illustrates.
Figure 7-8 Risk/Reward of a Collar plus credit spread
[OVM 7-8]

The Collar Study
An important validation of the basic collar came from a study in 2009 by
Edward Szado and Thomas Schneeweis of the Isenberg School of Management at
the University of Massachusetts. They published a paper1 on their study of the
collar strategy using data on the QQQQ (Powershares QQQ ETF) over a 122-
month period between March 1999 and May 2009. Szabo and Schneeweis tested
three different types of collar strategies: 1) completely passive collars at various
strike prices (i.e. strict rules for option selection with no variation throughout the
period); an “actively managed” collar strategy (where option selection was based
on predetermined signals for momentum, volatility, and macroeconomic factors);
and a strategy where the collar was applied to an actively managed mutual fund
that uses QQQQ as its performance benchmark.
The study tested collars constructed of one-month calls and one-month
puts, continuously replaced at each monthly expiration (similar to the way the
BXM index writes one-month calls as its standard methodology for benchmarking
covered call writing). But the study also tested the use of 3-month and 6-month
puts with the one-month calls as prior research by Szado had determined that the
purchase of longer-dated puts was a better approach to continuous put hedging.
(We found this particularly interesting as it supported our own views on ETF
collars where we simulate the purchase of 6-month or even longer dated puts
while continuously writing one-month calls (discussed further in Chapter Eight.)
In their published results, the authors of this study confirm our overall
position with regard to collars in general vs. put hedging or call writing by
themselves. In their words, “There are alternative option based approaches to
protecting equity based investments. The most obvious choice is typically the use
of protective puts. Unfortunately, the use of protective puts tends to be a relatively
expensive method of capital protection, especially in periods of high volatility…
Another option based approach is the buy-write or covered call strategy. The
covered call strategy typically entails the writing of call options against a long
underlying index position at a one-to-one ratio. A number of studies have
suggested that covered call writing can provide return enhancement as well as a
cushion to mitigate losses from market downturns…Unfortunately, covered call
writing still leaves an investor exposed to large down moves.”2
While the results on the so-called “actively-managed” scenarios slightly
outperformed the passive scenario, in order to judge its merits, one would have to
fully evaluate the particular interpretation and methodology of active management
applied in this study. Suffice it to say, however, that it does suggest that active
management can improve even more on the passive collar strategy -- something
that provides a lot of room for portfolio managers to explore further in their own
ways.

Focusing on the results of the simple passive collar strategies, the study
uses one particular collar scenario to represent the results of the passive collar
strategy during the time period in question: a six-month put purchase; one-month
call write; with the strike prices approximately 2% out of the money. In selecting
the 2% OTM scenario, the study notes strike price selection does have an effect,
but that the effect of market performance during the period is far more important.
That would follow intuitive conclusions, for example, that during a strong upward
market period, a collar strategy using 5% OTM strike prices will clearly
outperform one using say 1% OTM strikes. But the study also concluded that
regardless of market performance, the purchase of a six-month put vs. a one-
month put is the superior approach.
Table 7-6 shows the results in three separate time periods (due to the
differences in market performance during those periods) as well as in the total
122-month period covered by the study. The results favor the 2% OTM passive
collar strategy over the benchmark performance of the QQQQ itself for the entire
time period, though underperforming as expected during the steady upward part of
that time period and impressively outperforming during the market declines in the
early and late years. This of course is what protective option strategies are meant
to do. Even while underperforming, the collar strategy still had positive results,
and in all time periods the collar dramatically reduced standard deviation
(volatility).
Table 7-6 Results of the Szado-Schneeweis Collar Study
Time Period: 4/99 - 9/02 (tail-end of Internet bubble and subsequent decline)
QQQQ Collar
Performance* -23.3% +21.2%
Std Deviation 42.4% 13.7%
Max Drawdown -81.1% -7.5%
Time Period: 10/02 - 9/07 (steadily rising prices)
QQQQ Collar
Performance* 20.4% +5.2%
Std Deviation 17.5% 7.9%
Max Drawdown -12.4% -14.0%
Time Period: 10/07 - 5/09 (market decline from mortgage crisis)
QQQQ Collar
Performance* -19.8% -1.44%

Std Deviation 29.2% 11.6%
Max Drawdown -49.7% -17.9%
Time Period: Total 122 months
QQQQ Collar
Performance* -3.6% +9.3%
Std Deviation 30.4% 11%
Max Drawdown -81.1% -17.9%
*annualized
Source: “Loosening Your Collar: Alternative Implementations of QQQ Collars”, by
Edward Szado and Thomas Schneeweis, Isenberg School of Management, University
of Massachusetts, September 2009
Figure 7-9 Passive collar vs. QQQQ
[OVM 7-9.AI]
We view the results of the Szabo-Schneeweis not as a revelation or a
surprise but of an affirmation of what we have long believed and practiced. We
also view it as a beginning, not an end, to research and refinement of the use of
option strategies in managing ongoing risk. Perhaps even more encouraging than
the results of the passive strategy by itself, are the implications for the refinements
to the simple passive strategy that emanate from a manipulation of strike price and
duration as well as from the advent of active management. In short, if the strategy
is effective as implemented in a totally automated manner, just imagine how much
we may be able to enhance the results through additional refinements and an
overlay of active management.
Conclusions on Protective Option Strategies
Summing up our discussion on protective option strategies, we offer the
following conclusions.
1. Valuable risk-reducing tools, but with trade-offs. Put hedges and
covered call writes both provide highly flexible ways in which to tailor

the risks of individual securities during specific time periods, and thus
provide genuine value in reducing volatility and risk in equity
portfolios. Both, however, have associated trade-offs in terms of upside
potential, degree and efficiency of downside protection, degree of
volatility reduction, and cost. To ignore their value in managing the
risks of equity investments is to expose oneself to the vagaries of an
increasingly unpredictable and risk-prone marketplace.
2. The only meaningful tool for tailoring portfolio risk/reward. The ability
not just to manage but to truly fine-tune the risk/reward parameters of
an underlying security and to revise those parameters over time is an
enormous and vastly underutilized technique in equity management and
one that is only provided by options.
3. Calls are better in most situations, but puts are necessary for greater
protection. The covered call strategy is more appropriate for enhancing
return and providing modest downside risk. In most situations (i.e. time
periods), they will outperform put hedges. But, put hedges are more
effective when protecting against significant downside, though such
declines may not occur often.
4. The cost of put hedging can be effectively reduced. The cost of put
hedging can be offset through the use of long dated put purchases and
through tactics like spreading.
5. The combining of call writing with put hedging in collars has much
potential. The combining of a put hedge and a covered call write into a
collar strategy offers investors and managers a flexible ongoing risk
management approach that works very effectively against downside risk
without incurring costs that would significantly impact ongoing
performance. While caps to upside potential will necessarily exist, this
may prove for many to represent an acceptable compromise to
achieving significant volatility reduction and the virtual elimination of
catastrophic risk.
6. The collar is also versatile. Like the basic put hedge or the basic
covered call write, the basic collar can be combined with other
strategies (additional spreads, ratios, etc.) to provide an almost limitless
array of possibilities, not to mention all the potential follow-up actions
that become possible once the strategy is implemented
7. A continuous risk-protection strategy is possible. Perhaps most
importantly, the idea of using option strategies not just as an intermittent

tactic on individual securities, but as an ongoing tool for overall
portfolio management, is well within our grasp. Using options, we can
literally create entire portfolios to the risk-reward parameters we desire,
and the expansion of ETFs with options greatly facilitates that goal.
Such is the subject of Chapter Eight.
1. “Loosening Your Collar: Alternative Implementations of QQQ Collars”, by Edward Szado and
Thomas Schneeweis, Isenberg School of Management, University of Massachusetts,
September 2009
2. Ibid., p. 20