How to Hedge an ETF Using a Collar Options Strategy

The Collar Options Strategy

Back in mid-July, I discussed the basics of a collar strategy.

Now with more and more readers asking for hedge-based ideas, I want to discuss the strategy a bit further, this time using ETFs as my primary target.

It’s no secret that we’ve seen an incredible rally over the past year or so. And unfortunately, I don’t have a crystal ball that tells me the exact time to start hedging my positions or overall portfolio. But that’s okay, right? Because I do know of several options strategies that allow me to still take advantage of continued upside while maintaining protection just in case we see a pullback.

Again, the question of “how do I protect my profits using options?” has been rolling in far more frequently as of late. So today, I’m going to go over one of my favorite options strategies, step by step, for protecting profits without giving up potential future returns.

The Protective Collar – The Basics

A protective collar’s goal is to preserve hard-earned capital, while simultaneously allowing a position to continue making profits, albeit limited.

Unfortunately, greed deters individual investors from using collars. Hedge funds and even large institutional managers frequently use collars, so why aren’t most individual investors?

It’s because most investors don’t realize that collars not only protect their unrealized profits, they also allow you to hold a position that you don’t want to sell, but want some downside protection for just in case the stock takes a fall. Think earnings surprises or if you own a stock that pays a healthy dividend that you want to keep holding. Or maybe investors don’t realize it is one of the cheapest, yet most effective ways to reduce risk.

It doesn’t really matter the reason; it only matters that you start using this strategy to keep risk in hand. Because the most important aspect to successful, long-term investing is a disciplined approach to risk management. Without it, even the best strategies are inevitably doomed.

A collar options strategy requires an investor, who already owns at least 100 shares of a stock, to purchase an out-of-the-money put option and sell an out-of-the-money call option.

Think about of it as a covered call coupled with a long put.

  1. Long Stock (at least 100 shares)
  2. Sell call option to finance the purchase of the protective put
  3. Buy put option to hedge downside risk

*Collar Option Strategy: long stock + out-of-the-money long put + out-of-the-money short call

That’s right, you read bullet point three correctly. You can actually finance most of your protection, so the cost of a collar is limited, if not free. Again, this is why intelligent investors and professional traders use collars habitually.

The Trade – An Example Using the Russell 2000 ETF (IWM)

Let’s say you own a basket of ETFs and want to protect your return going forward. Or at least, produce a bit of income from your positions, while simultaneously hedging against a pullback.

Yes, you may have to forgo some upside profits in the process, that is if your position rockets higher, but you also have the reassurance that your hard-earned profits are being protected over the short to intermediate term. And again, you are still able to make a decent profit if the ETF continues to trend higher.

IWM-russell-2000-stock-chart-september-29-2021

For example, let’s say we own 100 shares of the Russell 2000 (IWM) ETF and would like to protect our return going forward. We still want to hold the position and participate in further upside. But we also realize that the ETF has had an incredible run and want some downside protection, specifically over the short to intermediate-term.

The ETF is currently trading for 221.94.

  1. With IWM currently trading for 221.94, we want to sell an out-of-the-money call as our first step in using a collar option strategy.

I typically look for a call that has roughly 30-60 days left until expiration. So, to keep things simple, I am going with the November options that are due to expire in 51 days.

IWM-calls-collar-options-strategy-november-expiration-cycle

I don’t want to sell calls that are too far out-of-the-money because I want to bring in a decent amount of premium to cover most, if not all, of the protective put I’m going to buy. But, of course, ultimately the choice depends on your personal agenda.

As a result, let’s say I try to sell a call with a delta somewhere around .40. The IWM 227 November call option with a delta of 0.39 fits the bill. We can sell the 227 call option in November for $5.00, or $500 per call.  We can now use the $500 from the call sold to help finance the put contract needed to achieve our goal of protecting returns.

  1. The next and final step is to find an appropriate protective put to purchase. There are many different ways to approach this step, mostly centered around which expiration cycle to use. Should we go out 30 days in expiration? 60 days? 120 days? It really is up to you to decide.

I prefer to going out as far as I can without paying too much for my protective put. In this case, I want to protect the position from a decline of 5% or greater.

I’m going to go out to the January expiration cycle with 114 days left until expiration. I plan on buying the 210 puts for roughly $8.10, or $810 per put contract.

IWM-puts-collar-options-strategy-january-expiration-cycle

This means that almost the entire cost of the January 210 puts will be covered by selling the November 227 calls.

Total Cost: January 210 puts ($805) – November 227 calls ($500) = $305 debit

And, we can actually add to our return, by selling more calls in December while still maintaining protection through January 21, 2022.

So, as it stands our upside return is limited to 227 over the next 51 days. If IWM pushes above 227 per share, at November expiration, our ETF would be called away. Basically, you would lock in any capital gains up to the price of 227. With IWM currently trading for roughly 222, you would tack an additional $5, or 2.3% to your overall return.

But the key reason to use the strategy is not about making additional returns, it’s about protecting profits. And through using a collar options strategy, in this instance, you are protected if IWM falls 5% lower or below 210 (where we purchased our put option).

Collars limit your risk at an incredibly low cost and allow you to participate in further, albeit limited, upside profit potential. I’m certain you won’t regret adding this easy, yet effective options strategy to your investment toolbelt.

As always, if you have any questions please feel free to email me.

3 comments on “How to Hedge an ETF Using a Collar Options Strategy

  1. Ankur Shah on

    Andy,

    Great timing on this article, given yesterday’s bloodbath. Could you use the same collar strategy on a Poor Man’s Covered Call position? Instead of being long the stock you would own LEAPs instead.

    Alternative collar: long LEAPs + out-of-the-money long put + out-of-the-money short call

    Finally, would you ever go further out in maturity on the short call relative to the long put? For example, you would sell a December short call to purchase a November put. This would allow you to purchase a higher strike price put because you would be taking in more premium initially. I think the only issue is that once the long put expires you may have an issue rolling out the short call further because it already has a longer maturity. I would love to hear your thoughts.

    Reply
  2. bruce mackay on

    very cool stuff. How about hedging at the portfolio level ? I haven’t seen any good studies that show the probabilities of putting on downside hedges if you want to protect an entire account from a 5 -10 % down move. Most are designed to protect from the infamous but infrequent black swan events. Many seem to count on the vix ladder and use 3% ( a purely random number it seems) over the course of the year and break it up by month. Great article for individual shares though. Thanks

    Reply
    • Andy Crowder on

      Bruce,

      Thanks for the kind words. Boy this is somewhat of a loaded question because each portfolio is designed differently. I look at everything through the lens of delta. If I wish to hedge my portfolio I do so through the build of my overall portfolio, using a wide variety of different strategies that takes advantage of different market environments. I try as hard as I can to stay delta neutral, but occasionally lean towards one side or the other. Position-size is also. a major factor. Using a mix of uncorrelated products is also imperative. Most don’t realize that it is in the build of the overall portfolio that carries the most weight. If you maintain overall risk through the use of the greeks, starting with delta, it is far easier to manage risk because you know at all times how much risk is on the table. Many of the methods mentioned work, especially for Black Swan events. I have no issue using strategies that cost 1% to 3% a year to keep black swan events at bay. Think about it, we pay for all types of insurance, car, home, life, etc., yet investors rarely protect their hard-earned money. Managing risk is the most important aspect of trading/investing. Anyone can buy a stock, ETF. Place a trade…that’s the easy stuff. Managing risk is what separates those that are successful and not over the long haul. Knowing risk prior to making a trade and understanding how that risk impacts your overall portfolio is crucial. Start with a disciplined plan for managing risk and you will prepared for any type of market event. I hope this helps and thanks again for the kind words.

      Reply

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