Send a Message

[contact-form-7 id="2362" title="Send a Message"]

DRS vs Collars

Down­load PDF


Seeking a Sustainable Downside Protection Strategy

Options-based strate­gies have been grow­ing rapid­ly over the last decade, both in terms of avail­able solu­tions as well as assets under man­age­ment. As of May 31, 2018, there are 176 funds with over $20bn AUM in the Morn­ingstar cat­e­go­ry “Options Based.” So what makes this options-based strat­e­gy so pop­u­lar?

As part of our ongo­ing com­par­i­son series, we will explore the fol­low­ing:

  1. What are the dri­vers of returns in a col­lar strat­e­gy?
  2. What are the risks in this strat­e­gy?
  3. What role does a col­lar play with­in a port­fo­lio?
  4. How does a col­lar com­pare to the Defined Risk Strat­e­gy?


The Collar Strategy

With a col­lar strat­e­gy, the man­ag­er typ­i­cal­ly has a long under­ly­ing posi­tion in a port­fo­lio of stocks. The man­ag­er seeks to pro­tect against down­side risk by pur­chas­ing an out-of-the-mon­ey put option. While it is cer­tain­ly pru­dent to pro­tect against down­side risk, put options obvi­ous­ly cost mon­ey.

To help off­set the cost of the put options, a col­lar strat­e­gy seeks to gen­er­ate income by writ­ing out-of-the-mon­ey calls against their mar­ket posi­tion. In effect, this caps the upside poten­tial of a col­lar. This is the fun­da­men­tal trade-off of a col­lar strat­e­gy: down­side pro­tec­tion is pur­chased in exchange for sell­ing away some of the upside poten­tial.


A col­lar typ­i­cal­ly has three com­po­nents:

  1. A long, buy-and-hold posi­tion in a mar­ket
  2. Long, out-of-the-mon­ey puts to pro­tect on the down­side
  3. Short, out-of-the-mon­ey calls to help pay for the puts

Below is a graph out­lin­ing the return pro­file of a cov­ered call strat­e­gy.

Collar Strategy - Swan Blog



A “Protected” Covered Call

If the above chart looks a bit famil­iar, it should. The col­lar strat­e­gy is close­ly relat­ed to the cov­ered call. In fact, two of the three legs of the col­lar are the same as the cov­ered call: the long equi­ty posi­tion and the short call posi­tion.

With the cov­ered call strat­e­gy, we stat­ed that one of the draw­backs is there is no down­side pro­tec­tion. One way of think­ing of col­lars is that they are essen­tial­ly “pro­tect­ed” cov­ered calls: using the pre­mi­um they gen­er­ate from the short calls not for income but to pur­chase down­side pro­tec­tion.


Drivers of Returns

The pri­ma­ry dri­ver of the col­lar strategy’s returns is the move­ment of the mar­ket itself. Not only is the direc­tion of the mar­ket impor­tant but the degree or mag­ni­tude of the market’s move is also sig­nif­i­cant. It is often said that a col­lar is a mod­er­ate­ly bull­ish strat­e­gy.

The key word is mod­er­ate­ly. Since the core of a col­lar is a long posi­tion in a port­fo­lio of equi­ties, the hold­er obvi­ous­ly hopes that the mar­ket goes up. How­ev­er, the risk is if the mar­ket goes up too much, the call options will go from being out-of-the-mon­ey to being in-the-mon­ey. Under such cir­cum­stances, the port­fo­lio man­ag­er real­ly only has a few options.

One, they could close out the trade and take a loss on the option trade. Two, the under­ly­ing asset could be called away and miss out on the gains. Or three, the port­fo­lio man­ag­er could cross their fin­gers and pray that the mar­ket revers­es direc­tion and dips back below the strike price before being called. Either way, the col­lar has effec­tive­ly sold off its upside poten­tial in a sharply ris­ing mar­ket.

Of course, the ben­e­fit to the col­lar strat­e­gy is when the mar­ket goes down. If the mar­ket goes past the put strike and if the col­lar was imple­ment­ed cor­rect­ly, the strat­e­gy should be pro­tect­ed from loss­es beyond a cer­tain point.

That is why the strat­e­gy is called a col­lar: The range of returns is meant to be “col­lared” with lim­it­ed down­side but also lim­it­ed upside.



The first risk is the most obvi­ous one: that a col­lar strat­e­gy has sold off its upside poten­tial. This is more of an “oppor­tu­ni­ty cost,” where gains beyond a cer­tain point are for­gone. How­ev­er, there are addi­tion­al risks to a col­lar. As always, the devil’s in the details.

Paying the Price for Puts

One risk has to do with what’s known as the skew of option pric­ing. In layman’s terms, skew refers to the fact that the prices of put options are usu­al­ly sig­nif­i­cant­ly high­er than the price of call options. If a col­lar strat­e­gy is buy­ing high-priced put options and hop­ing to off­set the cost by sell­ing low-priced call options, the col­lar might not be gen­er­at­ing pre­mi­um to ful­ly pay for the put.

This leaves the port­fo­lio man­ag­er with some dif­fi­cult choic­es.

  • The P.M. might accept that the cost of main­tain­ing the put might not be ful­ly off­set by the short calls. In such a case, the gap between the income gen­er­at­ed off the call and cost of the hedge will be an endur­ing drag on the port­fo­lio per­for­mance.
  • The P.M. might seek to off­set the cost of the put by sell­ing mul­ti­ple calls. For every put owned they might sell two, three, four or more calls to gen­er­ate enough pre­mi­um to pay for the put. This cre­ates a lever­aged bet, and if the mar­ket goes past the call strike, this approach can get very painful very quick­ly.
  • The P.M. might seek to buy or pur­chase cheap­er puts by mov­ing the pro­tec­tion fur­ther out-of-the-mon­ey. While the cost of the hedge would be reduced, so would the degree of pro­tec­tion. Essen­tial­ly, the investor would be on the hook for a larg­er tranche of loss­es before the pro­tec­tion kicked in.


Potentially Expensive Protection during Bear Markets

The oth­er major risk to a col­lar strat­e­gy is the cost of main­tain­ing it through a pro­longed bear mar­ket. When col­lars are estab­lished, the pro­tec­tion is usu­al­ly short-term in nature with the puts going out three months or so. Some­times more, some­times less, but three months is typ­i­cal.

What hap­pens to a col­lar strat­e­gy dur­ing an extend­ed mar­ket down­turn after its ini­tial hedge is cashed in? If the col­lar is to be main­tained, new put options will need to be pur­chased. But in a pro­tract­ed bear mar­ket like the dot-com crash (2000–02) or the Glob­al Finan­cial Cri­sis (2007–09), buy­ing new puts every quar­ter can become pro­hib­i­tive­ly expen­sive. The price for short-term pro­tec­tion sky­rock­et­ed in such envi­ron­ments and, in some cas­es, main­tain­ing a col­lar might be impos­si­ble thus leav­ing the under­ly­ing unpro­tect­ed from down­side risk.


Role Within a Portfolio

There is no “sil­ver bul­let” strat­e­gy that works well in every sit­u­a­tion. Every strat­e­gy has envi­ron­ments it works well or works poor­ly. Col­lar strate­gies tend to work best in either mod­est­ly upward mar­kets or short-term, minor cor­rec­tions of 5%-10%.

In the case of the for­mer, the col­lar will enjoy mod­est gains with­out too much upside called away. With the lat­ter, the short-term put offers some pro­tec­tion, and hope­ful­ly the sell-off isn’t too steep or too pro­longed. A case can be made for hav­ing a por­tion of one’s port­fo­lio in such a strat­e­gy.

How­ev­er, if one expects to cap­ture most of the upside in a strong bull mar­ket or if one is look­ing for bear mar­ket pro­tec­tion, a col­lar is not like­ly to be the best fit.


How Do Collar Strategies Compare to the Defined Risk Strategy?

The Defined Risk Strat­e­gy shares a few sim­i­lar­i­ties with col­lars, in the sense that it has a core, buy-and-hold, long posi­tion and pur­chas­es options to pro­tect on the down­side. How­ev­er, there are some key dif­fer­ences between these two strate­gies.

Where the col­lar has short-term puts, the DRS has long-term down­side pro­tec­tion on the equi­ty with a LEAPS put option. With a LEAPS put option, if and when we’re in the midst of a bear mar­ket, the DRS won’t be forced to pur­chase expen­sive puts for short-term pro­tec­tion or, as would be the worst case for the col­lar strat­e­gy, be left with­out pro­tec­tion.

Anoth­er dif­fer­ence is in the way they gen­er­ate income. While the col­lar strat­e­gy seeks to gen­er­ate income by writ­ing calls, the DRS does so via the simul­ta­ne­ous sale of both calls and puts in a mar­ket-neu­tral fash­ion. This pro­vides the poten­tial for more pre­mi­um and bet­ter oppor­tu­ni­ty to off­set the cost of the put option.

All this leads to a very dif­fer­ent return and risk pro­file than col­lar strate­gies: The DRS may pro­vide bet­ter pro­tec­tion in down mar­kets with more oppor­tu­ni­ty for upside poten­tial.


About the Author

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.



Important Notes and Disclosures

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results, and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it  260-SGI-062218

By |2018-10-02T10:52:58+00:00June 28th, 2018|Blog|Comments Off on DRS vs. Collars