From the November 2007 issue of Wealth Manager Web • Subscribe!

November 1, 2007

Cool Collars

How many advisors have clients concerned about growing their portfolios while at least partially protecting themselves against a really nasty drop? Actually, a better question is: Who doesn't? It's a tough problem, but at our firm we've come up with a strategy that allows us to pursue growth with a level of protection not typically present in traditional growth strategies. Whether your clients are very wealthy or just moderately well off, there's a neat little strategy that can get them the best of both worlds.

It's time to introduce your clients to options, even though you may get some uncomfortable responses. Many still view options as speculative, volatile securities suitable for investors who also practice witchcraft in their spare time. Others believe that options are only for big institutional investors, and that individual investors will be eaten alive if they try to use them. Don't let your clients believe any of this. Advisors with client accounts as modest as $100,000 or even less can make excellent use of options to protect capital or exploit opportunities in the stock market. And don't allow your clients to be scared off by the lingo: Caps, collars, puts and calls can all be broken down into plain English. Once your clients are clear on the definitions, they'll be more likely to buy into the goals and strategies.

It's worked at our firm, where we have bought protective puts and sold covered calls in isolated client situations for years. We have even established "collars" for clients who had a highly appreciated stock position, and for whom a stop order did not offer sufficient protection given their risk tolerance. A stop order may seem to be a simpler solution, and in fact, it works just fine--in an orderly market. The stock's price gradually falls, and when it trades at your stop price, a market or limit order is triggered--depending on the type of stop order you placed.

Problems occur when the market is not orderly. Let's say you have a stop order for a stock at $45 a share, and the stock currently trades at $50. Bad news hits overnight, and the stock opens the next day at $42. If you had a stop (market) order, you will be sold out at the market price--around $42, not $45. In other words, stop orders are not a bad protection mechanism, but they can also be like the home heating system that works fine until the temperature drops below zero...and then quits.

That's why at our firm, we decided we needed a strategy that allowed the investor a way to invest for aggressive, long-term appreciation, but with a "trap door" they could escape through if those aggressive investments did not pan out. We concluded that options would deliver a more reliable degree of protection against drops in these aggressive portfolio holdings than stop orders or even short positions. In particular, put options would give us the comfort of knowing that even if a $30-a-share asset fell to zero, we could still sell out at our put strike level--say, $27 as an example. Yes, we would have to pay a bit for that protection, but we felt that was a small amount of money to risk losing in exchange for the large potential upside we saw in the underlying ETFs and stocks in the portfolio. And if we decided that paying money out for put protection was expensive, we could buy down the cost in exchange for sacrificing some potential upside in the holdings--that is, we could sell call options against those same positions. The cash flow we received from selling the calls would offset some or all of the cost of the puts, and create a "collar" around the position.

We concluded that a carefully selected portfolio of five to 10 positions, each with a put option attached to prevent an unexpected disaster from spoiling our returns, would give us the best of both worlds. We could be aggressive in our ETF and stock selection, but the options would have our back in case our research was flawed or the market dragged everything down. Most importantly, we designed this as a portfolio--not simply a collar here and a collar there. We applied our experience in portfolio management and options to create something that could add a new dimension to our business. This system was so successful that we have begun tracking the performance of these accounts as a "composite" which we will ultimately have audited for compliance with Global Investment Performance Standards (GIPS), as we have done with some of our other models.

We call our system the "Option Collar Total Return and Preservation Strategy"--affectionately known in our office as the Octopus, a rather rough acronym. We boil down the intent and process involved in creating Octopus portfolios as follows:

GOAL: Long-term total return through investments in market segments with high expected returns and volatility, while systematically limiting downside risk.

HOW?

1. Identify volatile asset classes. Thanks to Wall Street's ingenuity, many market segments are now available through ETFs. And as the ETF market has grown, a liquid public options market has also developed around many issues. Examples of aggressive market segments we have used or considered are biotech, emerging markets, gold, oil and other commodities. These segments tend to be more volatile than most areas of the market. Since options values are driven in large part by volatility, this creates some interesting opportunities. The upside-to-downside ratio you can obtain on highly volatile equities is generally better than that on tamer issues.

2. Find ETFs that represent those asset classes. We prefer to use ETFs to invest in a sector, but a portfolio of stocks in this manner might also work.

3. Determine which of those ETFs have a sufficiently liquid options market. Put it this way: the Octopus needs enough water. If you buy a thinly traded issue or an issue with options that seldom trade, you greatly limit your ability to act before the options expire, should you decide you want to.

4. Assess which of the ETFs are at attractive buy points. We tend to like technical analysis as a tool to determine buy points. We also use it to determine where to strike our puts and calls. We don't use charts in a vacuum, though. We look for situations where both the fundamental case for buying something and the technical indicators we follow both say the same thing: buy!

5 (a). Buy the attractive ETFs. One of the best features of this strategy is that it allows you to be more aggressive in your purchases than you would be in an unhedged portfolio. Let's say you want to buy bank stocks because you think they have bottomed due to credit crunch fears reaching a crescendo. In a long-only portfolio, you might wait to see if the coast is clear before taking the plunge. With this strategy, you can try to pick a bottom. If you are right, you will capture nearly all the potential upside of the rebound. If you are wrong, you know exactly how much you will lose in a worst-case scenario. In addition, if the bank stocks have been volatile, you can collar a banking sector ETF instead of simply buying the put. The relatively expensive put (remember: high volatility means high options prices) can be funded in large part with the call you sell. Again, you can use stocks instead of ETFs. Just remember that you are taking on stock-specific risk if you do, and it is likely to be more risky than buying the index the stock belongs in.

5 (b). Buy out-of-the-money puts on the ETF. That is, buy puts whose strike price is below the current price that you paid for the ETF. I have found some cases in which the option pricing made it favorable to buy in-the-money puts, but those cases are in the minority.

5 (c). In some cases, sell in-the-money calls that create a costless collar, credit collar or small debit collar. Since there are so many possible situations you could encounter, the decision to complete the collar could take up an entire article of its own. Simply put, if you are willing to risk more downside in exchange for more upside, it is not as important to use the call side of the collar. What we have started to do very often in our portfolios is to buy the puts when we buy the stock, and if we are right (i.e., the stock goes up after we buy it), we then sell the puts at a price above the current price ("out-of-the-money") but at a level where we think the stock's run will end--or at least stall.

6. Monitor for profit opportunities or let the collar run its course. It is important to note that the options, unlike the underlying stock or ETF, have a limited life. If the stock neither drops below your put strike price nor climbs above your call price (if you sold calls) by the time the options expire, you can simply hold onto the stock and start the option portion of the strategy all over again.

There are two best outcomes for an Octopus strategy:

Outcome A: You buy a set of securities, buy your put protection, and at expiration, your securities have risen in price significantly. Yes, you can sell them, but you can also buy new puts at a higher strike price, effectively locking in a gain while retaining all of the future upside potential.

Outcome B: As an example, you buy an ETF at $60, and you pay $2 for put options on that ETF at a $55 strike price. The ETF goes to $70 well before the option expiration, and in your opinion, the up move in this security is over. So you sell the ETF and take a tidy $10 gain. Your opinion is correct, and the ETF plummets between the time you sold the stock and the expiration date of the options. At expiration, the ETF has dropped all the way to $40. You cash out your puts at a handsome $15 gain. Now, add it all up: $10 gain on the ETF, $15 gain on the put option, $2 cost of the put option. That's a total gain of $23 on a $60 security, while at all times you had set an impenetrable floor on your position. Now that's portfolio management!

The result? A portfolio in which each position has a predefined upside and downside limit. Thus, we take advantage of risk-reward opportunities that exist when you marry a put to--or "collar"--a volatile asset.

Our firm uses this strategy to manage separate accounts for our clients and clients of other advisors in a sub-advisory capacity. These are kept in a separate account for the sake of transparency and liquidity, and to keep costs reasonable. Although you might find hedge funds that do this, there's nothing like bringing creative thinking to your clients in a separate account package.

The nice part about Octopus investing is that it allows portfolio managers tremendous flexibility in how they want to pursue the twin goals of growth and risk control. That means that you can customize the portfolio to a particular client's preferences or your own portfolio management style. And it certainly won't surprise me to see this style of portfolio management gain traction in our industry as the years go on.

Robert Isbitts, CFS, is co-founder and Chief Investment Officer of the RIA firm Emerald Asset Advisors LLC (www.emeraldassetadvisors.com) and the author of Wall Street's Bull and How to Bear It. Worth Magazine selected him as one of their "Top 100 Wealth Advisors in the United States" in 2005 and 2006.

Reprints Discuss this story
This is where the comments go.