A couple of weeks ago, an experienced options trader sent out a query to other experienced options traders. She was dealing with a sad situation made sadder by others' actions. Her father had died. While dealing with his estate, she discovered that his managed retirement account had ridden a roller coaster of up and down movements over the last few years. When markets dipped severely, so did the account, and just as severely. Just before her father's death a few months ago and before she became involved, the account's value had finally climbed out of the dip and was escalating toward a higher pinnacle.
You can guess the rest of the story if you've looked at a chart lately.
There's a part of that story that's made sadder by others' actions. Being an experienced options trader and knowing that options were originally invented to hedge risk, she understood how they could be used to manage risk in portfolios. When she contacted those professionals who had been managing her father's retirement account about using options for that purpose, she encountered roadblocks and some belligerence, too. If risk couldn't be endured, these professionals asserted, then no investments should be made. She was still engaged in debating the issue with them when markets rolled down again.
She rather suspected that these particular professionals actually didn't understand how to use options to manage portfolio risk. She wanted to know if other experienced options traders had any of their portfolios under management by anyone other than themselves and how those accounts had fared, so she contacted some traders she knew.
Hearing that story, I was thinking that it was time for another article on collars and other such strategies. I've written about these tactics previously. By some coincidence, it was about this time that I heard from Ryan Renicker, CFA, one of the authors of a study mentioned in my October 3, 2009 article about collars. "Enhanced Call Overwriting," the 2005 study Renicker authored along with Devapriya Mallick while at Lehman Brothers, tested a strategy of active call writing. For those unfamiliar with call writing, calls are sold against long equity positions. The monies garnered from selling the calls gives some protection against losses during downturns. It must be noted that no call-writing strategy alone can protect against losses in the kind of markets we've seen lately, but their study was particularly important for another reason other than the pure hedging effect. That study and others like it was to have relevance in another strategy used to hedge portfolios: collars.
Reniker and Mallick specifically studied the effect on index-oriented overwriting portfolios. They tested various call-writing strategies, including at-the-money and out-of-the-money strategies. They tested writing front-month and back-month calls. Finally, they linked the number of calls sold to the behavior of a volatility index, the real genius of the study. Their strategy of selling fewer calls when an appropriate volatility measure showed "heightened short-term anxiety" and selling more "during periods of complacency" proved so useful that other researchers incorporated it into a test of collaring strategies . They concluded that during a period from 1997-2005 when the S&P 500 gained 5.5 percent, their "enhanced overwriting portfolio" gained 7.9 percent . Investors who are interested in learning more about their study can find it by searching using their names and the title of the study, but I am unfortunately unable to link it directly here.
Later, Edward Szado and Thomas Schneeweis incorporated some of these ideas into a comparison of passive versus active collaring techniques, concluding that the active techniques, making some of these adjustments for volatility, outperformed. For those unfamiliar with a collar, this strategy involves selling call positions against long equity or other positions, and then using the income gained by selling the calls to offset the cost of a protective put. Depending on one's risk tolerance and prediction about market behavior, various types of collars can be constructed. That October 3, 2009 article of mine, linked above, reviewed several studies about the performance of various collars and other such strategies during certain market conditions and periods. For those of you who have equity and other positions that you want to protect, I urge you to review that earlier article rather than rehashing it now.
While I don't want to rehash that entire article from 2009, the experienced option trader's query does prompt me to again remind subscribers to check their managed accounts. Those with monies that are professionally managed by others should examine how those portfolios have performed in recent weeks. Are the portfolios' balances taking the same roller coaster ride downhill that the experienced option trader's father's account was taking? Have those managing your accounts instead done a good job of hedging against losses? A "good" job depends on what you and your manager determined would be an acceptable amount of loss. Perhaps one trader wants more growth and less money spent on the insurance such techniques provide, and therefore is willing to endure a greater percentage drawdown. Perhaps fuddy-duddy investors, me being one for those managed accounts, at least, hate roller coasters and want more insurance. Therefore, fuddy-duddy investors have to be willing to give up some growth potential while paying for that insurance. No fair crying that they're not making as much money as they think they should during market rallies. That's the price we fuddy-duddy investors have to pay for our insurance.
That experienced options trader who wrote other traders had not had the opportunity to oversee that account until after her father's death. We have the opportunity now. Not only do we have the opportunity: we have the responsibility. If we're going to place monies with others to trade, we must find people capable of hedging risks in many ways and we must be clear about the risk we're willing to accept. Hedging risks can take many forms, including the ratio of the investments to the cash on hand, the construction of the portfolio to balance risks, and the use of various options strategies such as overwriting and collaring, among others, to provide some insurance. The price of the insurance is one cost we accept if we elect to use it. Others costs exist. If investors choose to hedge by selling calls against a long portfolio, then they accept the possibility that long stock could be called away if there's a strong rally. Tax consequences and the inability to participate in further rallying behavior could result unless they elect to buy back the sold calls at a loss or roll them into another strike.
Investors also have to accept the reality that selling calls against a long position provides some downside protection but protection that is limited to the credits taken in when selling the calls. Unless one has accrued many, many such profits, those profits will not be enough to offset the kinds of market declines we've had recently. Experienced options traders will understand that the shape of the chart for a covered-call position (stock plus sold call) is the same as that for a sold naked put.
Collaring techniques, because they employ long put positions, offer more downside protection, but they of course do so at a cost, too. The monies gained from selling calls are spent on buying long puts, and they may not be enough to totally offset the costs of the puts, depending on how the collar is constructed.
That experienced options trader is taking the responsibility of finding someone who knows how to manage risk using options or other tactics, just as it is all of our responsibilities. If your portfolios have not performed as you anticipated, research methods such as call selling, collars, ratio spreads or a multitude of other hedging techniques. Learn enough to know the pros and cons of each so that you can ask appropriate questions of the person who will be managing your money. Ask how they will manage the risk in your portfolio. Just as the last market downturn did, this one is affording you an opportunity to assess whether you were comfortable with the information you gave your money manager about how much risk you could accept and whether that money manager adequately addressed your concerns.