How has your portfolio performed since March 1999? What if I told you that one strategy could have nearly tripled your money over the 11-and-a-half-year period starting back then? Does that sound like something you might have been interested in learning about 12 years ago? All is not lost -- you can get acquainted with this strategy now and improve your returns over the next 10 years.
Before I tell you how, let me describe the basics of the strategy, known as a collar.
The collar: It's not just for dogs and businessmen!
Imagine that you have owned Apple (Nasdaq: AAPL) shares in your portfolio for several years, and you're concerned about protecting your accumulated profits on the position. In order to do so, you purchase a January 2012 put option at a strike price of $300. That put gives you the right to sell those shares at that price on or before the option expiration date, thereby capping any potential loss at 9%.
To offset the cost of the put, you simultaneously sell a January 2012 call option with a $375 strike price, selling someone the right to acquire the shares, should they reach that level. The net cost of this insurance: $2.05 per share, or roughly six-tenths of a percent of the value of your position. In establishing the collar, you are trading some of the upside on your stock position to limit your downside risk. Your upside and downside returns are capped -- thus the name "collar."
This collar wasn't creased during the "lost decade"
In an article published in the Journal of Trading, two academics at the University of Massachusetts compared the returns of passive and active collar strategies on an ETF (the PowerShares QQQQ (Nasdaq: QQQQ)) with those earned by a plain buy-and-hold strategy. Both collar strategies crushed the "buy-and-hold" investor, earning 185% and 290% while reducing risk by more than 60%.
The following table compares the results of the active collar strategy to 'buy-and-hold' over the period spanning March 1999 through September 2010:
|
Metric |
Buy-and-Hold: Powershares QQQ |
QQQ Active Collar |
|---|---|---|
| Annualized Return |
(0.3%) |
12.5% |
| Maximum Drawdown (Peak-to-Trough) |
(81.1%) |
(21.5%) |
| % Up Months |
54% |
67% |
Source: "Loosening Your Collar: Alternative Implementations of QQQ Collars, A Summary and Data Update, Fall 2010;" The Journal of Trading, Spring 2010, Vol. 5, No. 2: pp. 35-56.
The buy-and-hold strategy was a wash -- no surprise, since period covers the "lost decade" investors have been lamenting. The collar strategy, on the other hand, produced a 12.5% annualized return, which actually exceeds stocks' historical long-term return. Not only is this is a much better return, but it was achieved with significantly lower volatility. Witness the massive difference in the maximum peak-to-trough loss: An excruciating four-fifths loss for "buy-and-hold," against roughly one-fifth for the active collar.
A long way from breakeven
That difference contributed powerfully to the final results. Keep in mind that an 80% loss requires a fivefold increase to get back to breakeven, whereas a 25% gain can erase a 20% loss. A fivefold increase in the index will typically require a very long wait; note that we're still little more than halfway back to the Nasdaq's 2000 high.
Is the collar a magic strategy that will deliver a 12.5% annualized return with low volatility in any environment? Certainly not! These results partly stem from the underlying index ETF and the time period of the simulation. Had the authors chosen to look at the broader SPDR S&P 500 ETF instead, the margin of outperformance between the collar and buy-and-hold strategies would likely have been less dramatic. Nevertheless, I do think the results suggest individual investors can reduce downside risk and earn incremental returns by adding option strategies to their toolkit.
Put a collar on that stock!
Motley Fool Pro likes medical technology company Kinetic Concepts (Nasdaq: KCI) -- it's the second-largest position in Pro's real-money portfolio, and the team continues to rate the stock a buy. However, last October, Pro advisor Jeff Fischer was concerned that, on the back of several disappointments, a negative third-quarter earnings report could leave Kinetic's stock wounded. In order to protect the position, Jeff put on a collar that actually generated income for the portfolio. He received more for the calls he sold than he paid for the puts.
In this earnings season, stocks that sport stretched valuations and a wide spread in analyst estimates for the last quarter may be good candidates for collaring, since they could be vulnerable to an earnings miss. Four stocks that fit that profile today are Chipotle Mexican Grill (NYSE: CMG), VMware (Nasdaq: VMW), Las Vegas Sands (NYSE: LVS), and NVIDIA (Nasdaq: NVDA).
Your next step to a better-managed portfolio
If you're interested in finding out more about option strategies that could enable you to reduce the downside risk to your portfolio and add to your overall returns, drop your email in the box below. In return, Jeff Fischer will send you his free report, 5 Pro Strategies for 2011, along with an individual invitation to join Motley Fool Pro, which is reopening to new members for a short period of time. Get a head start on the market – Don't let your portfolio suffer another lost decade.
