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Summer 2016 – Volume 19 Number 1 | www.iiJAI.com

Risk and Return of Equity Index

Collar Strategies
RONI ISRAELOV AND MATTHEW KLEIN
 Risk and Return of Equity Index
Collar Strategies
Roni isRaelov and Matthew Klein

L
Roni isRaelov oss aversion leads many investors to In fact, the collar strategy buys one
is a managing director at seek tail-protection strategies, but expensive instrument (a put option) and sells
AQR Capital Management put options that provide the most another expensive instrument (a call option).
in Greenwich, CT.
[email protected]
direct insurance are expensive (both Even if the dollar “costs” offset, this is a bad
in terms of premium paid and lower expected deal relative to an alternative that does not
M atthew K lein returns). One popular solution for mitigating systematically buy overpriced instruments,
is an associate at AQR this cost is to finance the protective put option particularly when the purchased instrument
Capital Management in by selling call options. This strategy is referred is more overpriced than the one being sold.
Greenwich, CT.
to as a collar, and this article investigates the We will show that the collar strategy’s
[email protected]
collar’s risk and return characteristics. expected return can be decomposed into its
Index collars are typically described as equity risk premium and volatility risk pre-
providing protection at little to no cost for mium components. A collar has lower equity
those who are willing to trade upside poten- beta than the equity index, indicating that
tial for reduced downside risk. For instance, it collects less equity risk premium. In the
the Chicago Board Options Exchange case of the volatility risk premium, there is a
(CBOE) answers the question of who should netting of volatility exposures from the put
use equity collars (CBOE [2012a, 2012b]): and call options. The purchased put options
provide negative alpha to the equity index
• an investor who is looking to limit the because of the volatility risk premium paid
downside risk of a stock position at little to put sellers, whereas the sold call options
to no cost [emphasis added] provide some positive alpha. In the special
• an investor who is willing to forgo case of a zero-cost collar, the put option’s
upside potential in return for obtaining negative alpha should dominate because of
this downside protection the implied volatility smile, which has been
attributed to demand pressure by Bollen and
Do collar strategies successfully protect Whaley [2004]; Gârleanu, Pedersen, and
a position at little to no cost? The answer Poteshman [2009]; and Constantinides and
depends on how one chooses to define Lian [2015].
“cost.” Although there may be no upfront Lower expected return due to reduced
outlay if the put option and call option prices equity risk premium is incontrovertible: A
are the same, this alone reveals absolutely collar mechanically has lower equity expo-
nothing about the investment attractiveness sure than its underlying index. Buying a
of the trade and its impact on returns. put option reduces the portfolio’s equity

Summer 2016 The Journal of a lTernaTive invesTmenTs

exposure, as does selling a call option. This is true received mostly or fully offsets the put option premium
whether the collar provides a credit, provides a debit, paid). This objective typically drives collar portfolio
or is self-financing. This is also true whether the options construction. For instance, a desired protection level
are fairly, cheaply, or expensively priced. might be selected, such as three-month protection at
Negative alpha due to the put option’s volatility risk 95% of the current index value. The call option’s strike
premium is a well-documented, economically rational then might be selected such that its premium most
empirical observation.1 The collar’s upfront net cost may closely matches that of the purchased 5% out-of-the-
be negligible, but its negative alpha can have a material money put option. This approach provides the zero-cost
impact on investors’ returns. Investing in a typical collar collar. Alternatively, the call option’s strike and matu-
implementation has provided lower returns and a lower rity can be selected such that the strategy is zero-cost
Sharpe ratio than investing directly in the S&P 500 Index.2 on average.
In other words, investors would be better off simply The recently launched CBOE S&P 500 95-110
reducing their equity exposure. Collar Index (CLL) is an example of a collar implemen-
tation that buys three-month put options that are about
CONSTRUCTING A COLLAR 5% out-of-the-money at the time of purchase and sells
one-month call options that are about 10% out-of-the-
Exhibit 1 plots an example payoff diagram for money at the time of sale. This portfolio construction
the simple collar strategy in which the purchased put is actually far from zero-cost. In fact, on average this
option and written call option expire on the same date. strategy spends roughly $7.50 on put options for every
The exhibit illustrates how the collar strategy trades off dollar it collects from selling calls. As far as we are aware,
capped upside for limited downside. however, CLL is the only publicly available index that
Many degrees of freedom exist when constructing tracks an S&P 500 Index collar strategy. Given that it
a collar strategy. Most important are the strikes and was intended to serve as a benchmark for these strate-
maturities of the purchased put option and written call gies, we feel that it is reasonable to treat CLL’s perfor-
option. Collar strategies are often intended to be mostly mance as representative (or at least illustrative) of collars
or fully self-financed (in that the call option premium in general.3

Exhibit 1
Illustrative Collar Payoff Diagram
120

115

110
short call option
105 caps upside
Collar Payoff

100

95 long put option

limits downside
90

85

80
80 85 90 95 100 105 110 115 120
Index Value

Note: Illustration is long the equity index, long a put option with $90 strike price, and short a call option with $110 strike price. The prices of the two
options are equal, and they expire at the same time.

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

Exhibit 2
CBOE Collar Performance Summary (1986–2014)

S&P 500 Index CBOE Collar Index

Excess Return 7.3% 3.2%
Volatility 15.7% 10.7%
Sharpe Ratio 0.47 0.30
Beta 1.00 0.62
Upside Beta 1.00 0.68
Downside Beta 1.00 0.58

Notes: The table shows summary statistics for the S&P 500 Index (SPX) and the CBOE S&P 500 95-110 Collar Index (CLL). The date range is July
1, 1986, to December 31, 2014. Returns are excess of cash. “Excess Return” is an arithmetic average annualized return. Volatility, beta, and upside/
downside beta were computed using 21-day overlapping returns. We define downside beta as ∑t|xt < 0( yt − y ) * ( xt − x ) ∑t|xt < 0( xt − x )2 where yt is the collar’s
trailing 21-day return on day t, xt is the S&P 500’s trailing 21-day return on day t, and y– and x– are their full-sample average 21-day returns. The upside
beta, similarly, is ∑t|x > 0( yt − y ) * ( xt − x ) ∑t|x > 0( xt − x )2.
t t

COLLAR PERFORMANCE even after accounting for their reduced equity exposure.
This article explores the reasons why.
Exhibit 2 reports performance characteristics for The collar might be constructed such that it is self-
CLL and the S&P 500 Index (SPX) over the period July financing, but the prices of the options traded are not
1, 1986, through December 31, 2014. Over this period, really what matter. What really matters is the options’
the collar earned significantly less return in excess of prices versus their fundamental or actuarially fair values.
cash than had the S&P 500 Index: 3.2% per year for Equity index options tend to be expensive because of
CLL versus 7.3% per year for the S&P 500 Index. It has investor preference for loss avoidance, and out-of-the-
also had significantly lower volatility than the S&P 500 money put options tend to be more expensive than out-
Index: 10.7% for CLL versus 15.7% for the S&P 500 of-the-money call options. Hence, buying protection is
Index. The collar has realized a Sharpe ratio approxi- expected to hurt performance on a risk-adjusted basis
mately 35% lower than the S&P 500 Index. because put options are expensive. Selling upside helps
The collar is expected to have lower average risk-adjusted performance for the same reason, but not to
returns than the S&P 500 Index because its limited a great enough extent, which is why the collar strategy
loss and capped gain reduce its equity exposure. This has realized 1.3% per year of negative alpha.
f loor and cap are visible in Exhibit 3, which scatters To visualize, Exhibit 4 plots the payoff diagram to
the collar returns against the S&P 500 over the period, an illustrative self-financing collar in which the sold call
using 21-day overlapping returns. CLL’s 0.62 equity beta is cheap relative to the purchased put option. Comparing
is also visible as the slope of the regression line in the the mispriced collar to a fairly priced one, the call option
scatter. This number indicates that, as a starting point, strike in the former will be below the call option strike
the collar is expected to earn 38% less equity risk pre- in the latter. Therefore, it can be observed that the mis-
mium than the underlying S&P 500 Index. priced collar’s payoff is either identical to or worse than
However, there is more to the story than just the fairly priced collar’s payoff in all cases.
earning less equity risk premium. Had lost equity risk
premium been the only issue, the collar would have COLLAR PERFORMANCE ATTRIBUTION
had 4.5% annualized excess return. Its 3.2% annual-
ized excess return indicates the collar strategy has pro- When attributing the performance of option-
vided –1.3% of alpha per year on average. Somehow, the related portfolios, we find it more instructive to
options have significantly detracted from performance focus on risk exposures rather than payoff diagrams.4

Summer 2016 The Journal of a lTernaTive invesTmenTs

Exhibit 3
CBOE Collar Index vs. S&P 500 Index 21-Day Returns (1986–2014)
20%

15%
y = 0.62x - 0.0009
10% R² = 0.82
CBOE Collar Index (CLL)

5%

0%

–5%

–10%

–15%

–20%

–25%
–40% –30% –20% –10% 0% 10% 20% 30%
S&P 500 Index (SPX)

Notes: The chart plots overlapping 21-day returns for the SPX and the CLL. Data are present for the period from July 1, 1986, to December 31, 2014.

Exhibit 4
Illustrative Mispriced Collar Payoff Diagram
120
Collar with No Mispricing
115 Collar with Mispriced Call

110

105
Collar Payoff

100

95

90

85

80
80 85 90 95 100 105 110 115 120
Index Value

Notes: The “Collar with Mispriced Call” is long the equity index, long a put option with a $90 strike price, and short a call option with a $105 strike
price. The “Collar with No Mispricing” is long the equity index, long a put option with a $90 strike price, and short a call option with a $110 strike price.
In both scenarios, it is assumed that the prices of the two options are equal and that they expire at the same time.

Exhibit 5 shows the risk exposure arising from each Both of the put option exposures reduce the strategy’s
component of the strategy. The collar begins with a long expected return. Lower equity exposure means less equity
equity position, which provides positive equity exposure risk premium is collected, and long volatility exposure
and no volatility exposure. A put option is purchased, means that volatility risk premium is paid to the put option
which reduces equity exposure because a put option has seller. A call option is then sold, which further reduces
negative delta and introduces long volatility exposure. equity exposure because it has positive delta and introduces

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

Exhibit 5
Contributions to Strategy Returns

Equity Risk Volatility Risk Dynamic Equity

Premium Premium Timing
Long Equity Earns — —
Long Call Option Earns Pays Momentum
Long Put Option Pays Pays Momentum
Short Call Option Pays Earns Reversal
Short Put Option Earns Earns Reversal

Note: This table shows the risk exposure arising from each component of a collar strategy.

short volatility exposure. Whereas the long put option and original 28-year window. The collar realized 3.6% annu-
short call option have offsetting volatility exposures, both alized excess return, 3.2% lower than the S&P 500 Index.
option positions reduce the portfolio’s equity exposure. We define the passive equity exposure as the strategy’s
Israelov and Nielsen [2015a] proposed a perfor- average equity exposure. Passive equity exposure provides
mance attribution methodology for options-related 0.75 beta and 5.1% per year in equity risk premium.
portfolios. Their attribution identifies and measures a Equity exposure arising from option path dependence
portfolio’s equity timing arising from option convexity. is attributed to dynamic equity (–0.07 beta), and equity
Both option positions within the collar have dynamic exposure arising from correlation between equity returns
equity exposure, but they partially offset each other: and changes in implied volatility is attributed to volatility
Long options bet on momentum and short options bet (–0.03 beta).
on reversal. These timing bets do not perfectly offset The option positions have reduced the collar’s
because the call and put options may have different returns in three ways. First, 1.7% per year of equity
strikes and maturities. From a risk management per- risk premium is lost because of a 25% reduction in pas-
spective, the put option’s dynamic equity exposure may sive equity exposure. Second, the collar’s time-varying
be desired because it reduces the strategy’s equity expo- equity exposure has further detracted performance by
sure as losses accumulate in order to create a f loor—it 0.5% per year. However, there is no compelling ex ante
is a form of drawdown control. The short call option’s expectation that the net dynamic exposure should have
dynamic exposure also reduces the collar’s equity expo- non-zero returns, and the 0.5% loss is not statistically
sure as gains accumulate; however, it is unclear why this significant. Finally, the strategy’s net volatility exposure
would be desired unless an investor seeks to express a has reduced returns by 1.0% per year. The volatility risk
very specific view on equity market reversals. premium is therefore responsible for roughly one-third
To better understand the drivers of the CBOE of the CBOE Collar Index’s underperformance relative
Collar Index’s performance, we construct a portfolio to the S&P 500 Index.
that mimics the collar index and decompose its return Exhibit 7 further decomposes the strategy’s net
in excess of cash, as suggested by Israelov and Nielsen volatility exposure into the put and call options’ respec-
[2015a], into (1) passive equity exposure, (2) dynamic tive contributions. As the –0.29 correlation indicates,
equity exposure, and (3) volatility exposure. The decom- these two components partially offset each other by
position is reported in Exhibit 6. Results are reported providing volatility exposures in opposite directions.
over the period March 25, 1996, through December Buying protection via put options significantly detracts
31, 2014, a smaller window than considered in Exhibit from the strategy’s performance because options tend
2 because of data availability. to be richly priced, costing 1.6% per year on average
The strategy characteristics over the shorter 18-year in volatility risk premium paid to put option sellers. In
sample are similar to those reported earlier over the this case, selling call options recovered less than 40% of

Summer 2016 The Journal of a lTernaTive invesTmenTs

Exhibit 6
Collar Return Decomposition (1996–2014)

S&P 500 Index Collar Strategy Passive Equity Dynamic Equity Volatility
Excess Return 6.8% 3.6% 5.1% –0.5% –1.0%
Volatility 16.5% 11.4% 12.3% 4.0% 2.1%
Sharpe Ratio 0.41 0.32 0.41 –0.13 –0.45
Risk Contribution 100% 100% 109% –10% 0%
Beta 1.00 0.64 0.75 –0.07 –0.03
Upside Beta 1.00 0.69 0.74 –0.05 0.00
Downside Beta 1.00 0.61 0.75 –0.09 –0.05

Notes: The table shows summary statistics for the S&P 500 Index, an S&P 500 collar strategy mimicking the methodology of the CLL, and the collar
strategy’s decomposition. The collar backtest is long the S&P 500 Index, long 5% out-of-the-money front-quarter S&P 500 put options, and short 10%
out-of-the-money front-month S&P 500 call options, all held to expiry. Following Israelov and Nielsen [2015a], the collar returns are decomposed into (1)
passive equity exposure, (2) dynamic equity exposure, and (3) volatility exposure.
Returns are excess of cash. The date range is March 25, 1996, to December 31, 2014. “Excess Return” is an arithmetic average annualized return.
Risk contribution is defined as the covariance of the component with the full strategy, divided by the variance of the full strategy. Volatility, beta, and
2
upside/downside beta were computed using 21-day overlapping returns. We define downside beta as ∑t|xt <0( yt − y ) * (xt − x ) ∑t|xt <0(xt − x ) where yt is the col-
lar’s trailing 21-day return on day t, xt is the S&P 500’s trailing 21-day return on day t, and – and x– are their full-sample average 21-day returns. The
y
2
upside beta, similarly, is ∑t|xt > 0( yt − y ) * ( xt − x ) ∑t|xt > 0( xt − x ) .

Exhibit 7
Volatility Component Return Decomposition (1996–2014)

Long Volatility Short Volatility

Volatility (Put Option) (Call Option)
Excess Return –1.0% –1.6% 0.6%
Volatility 2.1% 2.2% 0.8%
Sharpe Ratio –0.45 –0.70 0.75
Risk Contribution 0% –2% 2%
Beta –0.03 –0.04 0.02
Upside Beta 0.00 –0.02 0.02
Downside Beta –0.05 –0.07 0.01
Correlation — –0.29

Notes: The table shows summary statistics for the volatility component of an S&P 500 collar strategy mimicking the methodology of the CLL, and it
further decomposes this component into the put and call options’ respective contributions. The collar backtest is long the S&P 500 Index, long 5% out-of-
the-money front-quarter S&P 500 put options, and short 10% out-of-the-money front-month S&P 500 call options, all held to expiry. Following Israelov
and Nielsen [2015a], the collar returns are decomposed into (1) passive equity exposure, (2) dynamic equity exposure, and (3) volatility exposure. For this
table, the volatility component is then decomposed into the put and call options’ contributions.
Returns are excess of cash. The date range is March 25, 1996, to December 31, 2014. “Excess Return” is an arithmetic average annualized return.
Risk contribution is defined as the covariance of the component with the full strategy, divided by the variance of the full strategy. Volatility, beta, upside/
downside beta, and correlation were computed using 21-day overlapping returns. We define downside beta as ∑t|xt < 0( yt − y ) * ( xt − x ) ∑t|xt < 0( xt − x )2 where
yt is the collar’s trailing 21-day return on day t, xt is the S&P 500’s trailing 21-day return on day t, and y– and x– are their full-sample average 21-day
returns. The upside beta, similarly, is ∑t|xt > 0( yt − y ) * ( xt − x ) ∑t|xt > 0( xt − x )2 .

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

the volatility risk premium paid out by purchasing put downside beta may be attributed to dynamic equity expo-
options, about 0.6% per year. sure, indicating that investors could have achieved much
Net long volatility exposure is not a necessity of of the desired downside protection by dynamically trading
collar construction. Alternative approaches to option selec- the index and without trading options. Dynamic equity
tion in terms of maturities or strikes can potentially lead to trading can protect against downtrends; long option posi-
a collar that has positive alpha because it is net short vola- tions can protect against both downtrends and gaps. Thus,
tility. The benchmark collar example is nevertheless a good on the margin, options provide gap protection.
reminder that buying put options and selling call options is
not necessarily neutral in terms of expected return. PATH DEPENDENCE
The collar successfully provides asymmetric beta to
the S&P 500, although the asymmetry is moderate. To Path dependence is one of the significant chal-
estimate it, we can calculate the strategy’s downside and lenges posed by portfolios containing options. The
upside betas. Specifically, we define downside beta as: portfolio’s exposure to equity and volatility are mean-
ingfully affected by its options’ strikes and maturities as
∑ t|xt < 0 (y − y ) * (x − x )
t t
(1)
well as by changing market conditions. Unfortunately,
the resulting exposures might not necessarily ref lect the
∑ (x − x )
t|x < 0 t
t
2
manager’s views.
To illustrate the effect of path dependence,
in which yt is the collar’s trailing 21-day return on day t; Exhibits 8 and 9 provide examples of the CBOE Collar
xt is the S&P 500’s trailing 21-day return on day t; and Index’s risk exposures on two option expiration (rebal-
−
y and − x are their full-sample average 21-day returns. ance) dates representing different risk environments.
The upside beta, similarly, is: December 19, 2008, represents a high-volatility envi-
ronment with the VIX Index at 44.9, and September 19,
∑ t|xt > 0 (y − y ) * (x − x )
t t
(2)
2014, represents a low-volatility environment with the
VIX Index at 12.1.
∑ (x − x )
t|x > 0 t
t
2
The collar strategy is the same on both dates, but
its risk exposures on these two dates markedly differ.
Using these definitions, the collar’s downside beta is On December 19, 2008, the collar had approximately
0.61 versus its overall 0.64 equity beta and its 0.69 upside 0.5 S&P 500 Index exposure. On September 19, 2014,
beta. Interestingly, approximately half of the asymmetric its exposure to the S&P 500 was 50% higher. It is not

Exhibit 8
High-Volatility Environment (December 19, 2008)—S&P 500: 887.88 and VIX: 44.9

Long Short Collar Greek Exposure

3 Month Put 1 Month Call (Combined)
Strike 855 995 —
Strike/Index Value 96% 112% —
Price/Index Value 7.0% 0.5% —
Implied Volatility 45.1% 34.4% —
Delta Contribution –0.39 –0.12 0.49
Gamma Contribution 1.7% –2.1% –0.43%
Vega Contribution 0.19% –0.05% 0.14%

Note: This table provides an example of the risk exposures for the CLL on December 19, 2008 (a high-volatility environment).

Summer 2016 The Journal of a lTernaTive invesTmenTs

Exhibit 9
Low-Volatility Environment (September 19, 2014)—S&P 500: 2010.40 and VIX: 12.1

Long Short Collar Greek Exposure

3 Month Put 1 Month Call (Combined)
Strike 1910 2300 —
Strike/Index Value 95% 114% —
Price/Index Value 1.1% 0.0% —
Implied Volatility 14.5% 16.1% —
Delta Contribution –0.24 –0.00 0.76
Gamma Contribution 4.4% –0.1% 4.28%
Vega Contribution 0.16% 0.00% 0.15%

Note: This table provides an example of the risk exposures for the CLL on September 19, 2014 (a low-volatility environment).

Exhibit 10
CBOE Collar Index’s Equity Exposure (1996–2014)

1.0

0.8

0.6

0.4

0.2

0.0

–0.2
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Notes: The chart plots the delta exposure for an S&P 500 collar strategy mimicking the methodology of the CLL. The backtest is long the S&P 500
Index, long 5% out-of-the-money front-quarter S&P 500 put options, and short 10% out-of-the-money front-month S&P 500 call options, all held to
expiry. The date range is from March 25, 1996, to December 31, 2014.

clear why a collar investor should want to have 50% For example, on March 14, 2008, the strategy would
higher equity exposure on September 19, 2014, than on have been long a deep in-the-money put option with a
December 19, 2008. Exhibit 10 plots the collar index’s delta of –1.00 and short a deep out-of-the-money call
equity exposure over the period beginning in 1996 and option providing a delta exposure of –0.03, resulting in a
ending in 2014 and shows how the collar index’s equity portfolio delta exposure of –0.03. This unusual situation
exposure has considerable variation over time. Its 95% arose because the S&P 500 had fallen over 13% since the
confidence interval is a low of 0.16 and a high of 0.99. put option had originally been purchased, so instead of
In fact, on a few occasions the collar index remark- straddling the spot index value, the call and put strikes
ably has close to zero or slightly negative equity exposure. were now both above it. Further exacerbating the issue,

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

the strikes were at this point unusually close together times over the period, meaning that the portfolio was
since the call strike was selected to be 10% above the sometimes positively exposed to changes in implied vol-
February 2008 spot value whereas the put had been atility, whereas at other times it was negatively exposed.5
selected to be 5% below the much higher December Its net vega exposure was 0.077% on average, and it was
2007 spot value. positive 94% of the time.
The collar strategy also exhibits significant varia- For all intents and purposes, on September 19,
tion in its exposure to volatility as defined by both its 2014, the collar was a protective put strategy. The call
gamma, which measures an option’s convexity to the option’s premium, delta, gamma, and vega were all
underlying security price, and by its vega, which mea- nearly zero; only the equity position and put option
sures an option’s sensitivity to implied volatility changes. contributed to the collar’s risk exposure. This is poten-
On December 19, 2008, the collar was short gamma, tially troublesome because the collar approach is typi-
whereas on September 19, 2014, the collar was long cally recommended as an alternative to buying expensive
gamma. Not only was the sign different, but so, too, was put options for protection. For an investor who finds
the magnitude of the exposure. Gamma was nearly 10 a protective put to be unattractive, it is confusing that
times larger on September 19, 2014, than on December the collar would be deemed an attractive alternative on
19, 2008. It is not clear (to us) why a collar investor dates such as this.
should want to be long significant gamma in September In fact, over the period 1996 through 2014, we esti-
2014 and short moderate gamma in December 2008. mate that the collar strategy’s risk exposures were effec-
Exhibit 11 plots the collar index’s gamma exposure tively equivalent6 to those of a protective put strategy on
over the period beginning in 1996 and ending in 2014 19% of days. These dates were determined solely by the
and shows how the collar index’s volatility exposure also path dependence of the portfolio and not by any active
has considerable variation over time. Consistent with the decision on the part of an investor. Because protective
collar paying out volatility risk premium because of its put strategies are long volatility, however, this implies
net long volatility exposure, it is long gamma 84% of that the collar was (at least in part) unintentionally acting
the time, and its average gamma is 0.02. Likewise, the as a volatility timing strategy. Given a belief in reason-
collar’s net vega exposure also changed signs multiple ably efficient markets, it seems extremely dubious that

Exhibit 11
CBOE Collar Index’s Gamma Exposure (1996–2014)

0.4

0.3

0.2

0.1

0.0

–0.1

–0.2

–0.3

–0.4
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Notes: The chart plots the gamma exposure for an S&P 500 collar strategy mimicking the methodology of the CLL. The backtest is long the S&P 500
Index, long 5% out-of-the-money front-quarter S&P 500 put options, and short 10% out-of-the-money front-month S&P 500 call options, all held to
expiry. The date range is from March 25, 1996, to December 31, 2014.

Summer 2016 The Journal of a lTernaTive invesTmenTs

such a timing strategy (which is easily computable ex COLLAR ALTERNATIVES
ante) should work. Therefore, collar investors who view
protective puts unfavorably should be concerned that a An investor who demands equity gap protection
collar may resemble one so frequently. has limited alternatives to expensive protection-buying
strategies. Gap protection requires long volatility expo-
sure, and long volatility exposure has negative expected
POTENTIAL COLLAR BENEFITS
returns because someone has to underwrite this financial
Although the drawbacks discussed in the previous insurance and will not do so for free.
two sections (significant path dependence, dynamic Alternatives to collar strategies can help investors
equity timing exposure, and partially offsetting vola- reduce their downside risk if they are willing to forgo
tility exposures) apply to all collars to some degree, the gap protection. We will analyze four candidates. As
precise magnitudes of their impacts will vary depending a starting point, the most direct method of reducing
on the particular option-selection strategy used. These downside risk is simply to reduce overall risk itself by
drawbacks seem to be particularly acute for common selling some equity. Similar to the collar strategy, this
collar constructions, but a case could potentially be approach has lower expected return because it col-
made for collar strategies or collar-like strategies that lects less equity risk premium, but it does not pur-
attempt to minimize the f laws while keeping intact most chase negative-alpha options and thus should have a
of the downside protection benefits. superior risk-adjusted return. A second alternative is a
In particular, one potentially promising collar con- protective put strategy that, like the collar, reduces its
struction could sell at-the-money, short-dated call options equity exposure by buying put options. Since it does
while buying deep-out-of-the-money, longer-dated puts. not attempt to offset the cost through call option sales,
Such a construction would have the advantage that, on however, this strategy has negative-alpha long volatility
net, it should be short volatility and thus collect the vola- exposure. The third alternative we consider is the cov-
tility risk premium rather than pay it out, as in more ered call strategy, which also has lower equity exposure
typical constructions. However, unlike with a pure equity than the underlying index but adds alpha to the port-
or covered call construction, the purchased put options folio in the form of volatility risk premium collected
would still provide a f loor to protect against large gaps. by selling call options. As a final alternative, we look
A similar case could be made for a collar-like at the risk-managed covered call strategy proposed by
strategy that sells delta-hedged at-the-money call options Israelov and Nielsen [2015a], which dynamically trades
while buying delta-hedged deep-out-of-the-money the equity index to maintain a constant equity expo-
puts. This portfolio can be thought of as a protected sure, hedging the traditional covered call’s time-varying
short volatility strategy, selling at-the-money options to equity exposure. Since the various strategies differ sig-
earn volatility risk premium and buying deep out-of- nificantly (by construction) in their average return,
the-money to protect against gaps (i.e., large spikes in volatility, and betas, for ease of comparison we lever
volatility). Careful selection of option strike and matu- each strategy to provide the same ex post compounded
rity should provide a strategy that maintains a net short return as the equity index collar and then compare their
volatility exposure. risk characteristics.
As these examples show, we do not intend to Exhibit 12 reports summar y characteris-
make the claim that all possible index collar strategies tics for these portfolios. Since 1996, CLL has pro-
should be avoided in all possible investment environ- vided 2.3% annual compounded excess return.7
ments. We are simply pointing out that much of the A portfolio that invests 36% of its net asset value (NAV)
traditional framework for thinking about these strate- in the S&P 500 Index and the remaining 64% in cash
gies is muddled, and a clearer picture of both the posi- would have earned the same 2.3% compound excess
tives and negatives emerges from a closer, more careful return. Investing 49% of NAV in the CBOE S&P 500
analysis. Rather than indicting collar strategies in general, BuyWrite Index (BXM) and 51% in cash or 45% of NAV
we believe that, as typically implemented, a collar would in the risk-managed BuyWrite strategy and 55% in cash
likely be a poor choice for most investors. also matches the collar’s annual compounded return.

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

Exhibit 12
Collar Alternatives Performance Summary (1996–2014)

CBOE S&P 500 CBOE CBOE Hedged

S&P 500 Collar Index PPUT Index BXM Index BXM Index
Index Index (36%) (101%) (49%) (45%)
Excess Return (Geom.) 5.2% 2.3% 2.3% 2.3% 2.3% 2.3%
Volatility 16.5% 11.4% 5.9% 13.2% 5.6% 4.1%
Sharpe Ratio 0.32 0.20 0.39 0.17 0.41 0.55
Beta 1.00 0.63 0.36 0.73 0.30 0.24
Upside Beta 1.00 0.69 0.36 0.82 0.25 0.23
Downside Beta 1.00 0.59 0.36 0.68 0.34 0.25

Notes: The table shows summary statistics for the S&P 500 Index, the CLL, as well as four strategies levered to have the same return as CLL: the S&P
500 Index, the CBOE S&P 500 5% Put Protection Index (PPUT), the CBOE S&P 500 BuyWrite Index (BXM), and the risk-managed covered call
strategy proposed by Israelov and Nielsen [2015a] (a strategy that dynamically trades the equity index to maintain a constant equity exposure, hedging the
traditional covered call’s time-varying equity exposure). These four strategies were levered 36%, 101%, 49%, and 45%, respectively.
Returns are excess of cash. The date range is March 25, 1996, to December 31, 2014. “Excess Return (Geom.)” is a geometric average
annualized return. Volatility, beta, and upside/downside beta were computed using 21-day overlapping returns. We define downside beta as
2 – and
∑t|x < 0( yt − y ) * ( xt − x ) ∑t|x < 0( xt − x ) where y is the collar’s trailing 21-day return on day t, x is the S&P 500’s trailing 21-day return on day t, and y
t t t t 2
–
x are their full-sample average 21-day returns. The upside beta, similarly, is ∑ t|xt > 0 t ( y − y ) * ( xt − x ) (
∑ t|xt > 0 tx − x ) .

A very small amount of leverage would be required to All three of these alternatives have achieved the
match the collar’s compounded return by investing in same return as the CBOE Collar Index, but with lower
the CBOE S&P 500 5% Put Protection Index (PPUT), risk, higher Sharpe, and lower beta. In fact, compared
with 101% of NAV needed. to each the collar has even had higher downside beta
Over the time period, the collar’s performance per unit of average return. Unlike these alternatives,
has been superior to the protective put strategy’s. While however, the collar does provide downside gap protec-
PPUT realized 13.2% annualized volatility in achieving tion. But is it worth the cost?
its return, the collar required only 11.4%. This outper-
formance should be expected based on the two strategies’ BLACK SWANS
portfolio constructions because the collar’s call option
sales provide a positive alpha boost relative to the pro- Based on the historical evidence, one should
tective put by having a smaller long-volatility exposure. expect selling delta-hedged options to be more profit-
The comparison to the other alternatives, however, able than buying them, since the volatility risk premium
is much less favorable for the collar. In all three instances, is positive on average. As we have shown, this implies
the collar has been a significantly more volatile approach that the collar strategy should perform poorly relative
to achieving the same return: 11.4% annualized volatility to alternate ways of reducing downside risk. One pos-
versus 5.9%, 5.6%, and 4.1% for the S&P 500, BuyWrite, sible objection, however, is that forming an expectation
and risk-managed BuyWrite portfolios, respectively. The by just looking at the historical record may implicitly
partially invested S&P 500 portfolio matches the collar’s underweight the probability of rare, extremely nega-
return with lower volatility because the S&P 500 has no tive events—black swans. A skeptic can argue that option
negative alpha. Investing in the BuyWrite strategy allows sellers have merely been “lucky” in recent years, so the
for even lower volatility because selling call options collar may start looking better again if one adjusts one’s
earns the volatility risk premium, and the risk-managed assumption about the expected frequency of black swans.
BuyWrite further reduces risk by hedging the BuyWrite’s Although this is a reasonable objection, it turns out
uncompensated dynamic equity exposure. that black swans would need to be unreasonably frequent

Summer 2016 The Journal of a lTernaTive invesTmenTs

to make the collar to start looking attractive. Mimicking lose money in an equity crash. The explanation is that
an argument made by Israelov and Nielsen [2015b], we this collar construction has a significantly net long vega
considered hypothetical market crashes of a magnitude exposure (0.15%), so all else equal, it should make money
similar to the October 1987 crash. Specifically, in each as implied volatility increases if the increase is similar
of these events we assumed that the S&P 500 falls 20% across the term structure. As shown in Exhibit 13, the
in one day and implied volatility spikes to 150%.8 150% post-shock implied volatility in our simulation
With these assumptions, we can estimate the black is extreme enough that the gains from the portfolio’s
swan return earned by a collar portfolio (based on CLL positive vega exposure outweigh the losses one would
construction) consisting of a long position in the S&P expect from its beta alone.
500 Index, a long position in a 5% out-of-the-money The sign of the collar’s return in our simulation
put option with three months to expiration, and a short is also consistent with the positive observed return of
position in a 10% out-of-the-money call option with CLL on “Black Monday” (October 19, 1987), a date on
one month to expiration. Although the index would be which it gained 3.3% despite the S&P 500 falling 20.5%.
down 20% on the day and the short call option position As in our simulated case, much of the positive return
would also be down 5.3%, these losses would be offset can be explained as a result of the portfolio’s positive
by a 32.2% gain in the long put position, resulting in vega exposure. However, the actual CLL (unlike our
the overall collar portfolio being up 6.9%. simulation) also benefited from some extra “luck” in the
The fact that the collar portfolio made money in sense that it happened to have an unusually low exposure
our simulated black swan event may seem surprising. to equity moves on the eve of the crash. Specifically,
Although a collar should provide some downside pro- the S&P 500 fell significantly between the September
tection, its long-term beta to the underlying index is and October option expiration dates, which meant that
still positive, so at first glance one would expect it to on the Friday before the crash, the call option’s strike

Exhibit 13
Collar Simulated Black Swan Return by Post-Shock Implied Volatility

8%

6%

4%
Collar Black Swan Return

2%

0%

–2%

–4%

–6%

–8%
20 30 40 50 60 70 80 90 100 110 120 130 140 150
Post-Shock Implied Volatility

Notes: The chart plots the simulated black swan return for a collar portfolio as a function of the post-shock implied volatility of the options in the portfolio.
The collar portfolio (based on the CLL construction) consists of a long position in the S&P 500 Index, a long position in a 5% out-of-the-money put
option with 3 months to expiration, and a short position in a 10% out-of-the-money call option with 1 month to expiration. Pre-shock, both the put and
call options are assumed to have implied volatilities of 18%. To generate the black swan returns, we applied hypothetical market crashes of a similar magni-
tude to the October 1987 crash. Specifically, in each of these events we assumed that the S&P 500 falls 20% in one day, while the implied volatilities of
both the put option and the call option increase to the specified post-shock implied volatility level.

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016

would have been roughly 110% of the S&P 500 level, exposure and thus earns less equity risk premium,
while the put option’s strike would have been around and (2) it purchases put options that are more richly
106% of the level. We can estimate that CLL therefore priced than the call options it sells and thus pays vola-
would have had only a 0.26 delta exposure on October tility risk premium. It is folly to believe that collaring
16, 1987, which is in the 4th percentile since 1996 and one’s equity exposure necessarily leaves one’s expected
well below the median delta exposure of 0.78. Without return intact.
this path dependence effect, CLL’s return on “Black The equity index collar is a complex, low-beta
Monday” could have been considerably worse. strategy, often with negative alpha. It has time-varying
Returning to our simulation, we can use our cal- equity and volatility exposures, and these dynamic
culated 6.9% return then to estimate the black swan exposures may be unrelated to desired risk allocations
frequency assumption required for the collar’s expected and forecasts of expected returns. Those who wish to
return to equal the expected return of being long the reduce their equity risk have a simple, elegant, effective,
S&P 500. Specifically, we divide the difference in the and transparent solution in their toolkit: They can sell
two strategies’ black swan returns (6.9% – –20% =26.9%) a portion of their equities. Buying and selling options
by the difference in observed annualized returns (7.3% each month is unnecessary.
– 3.2% = 4.1%) to arrive at a frequency assumption of However, reducing a portfolio’s equity exposure
one black swan event every 6.6 years. clearly and mechanically reduces its expected return. If
If requiring the collar to match the return of the investors must maintain their portfolio’s return target,
underlying index (collar descriptions give the impression then alternatives can replace the lost equity risk premium
that they do) seems too extreme, a collar investor may with alpha. Volatility risk premium is one potential can-
instead be content with just matching the beta-adjusted didate. An equity index covered call, which simultane-
S&P 500 return. This investor would, in other words, be ously reduces equity exposure and adds volatility risk
hoping that the long delta-hedged put option expected premium, is one potential solution.
return and the short delta-hedged call option expected
return offset each other. Using a calculation similar to ENDNOTES
the one described in the previous paragraph, the black
swan frequency required for this to occur for the CLL 1
Bakshi and Kapadia [2003] analyzed delta-hedged
construction is approximately once every 22 years. index option returns and found evidence in favor of a vola-
Given the fact that there has only been one S&P tility risk premium. Hill et al. [2006] showed that covered
500 crash of a similar magnitude since at least 1950 call returns are higher because of the spread between implied
and realized volatility.
(and one crash for the Dow Jones Industrial Average of 2
In general, a typical collar strategy should have lower
a similar magnitude since 1897), we would argue that
expected returns and a lower expected Sharpe ratio than
these frequencies seem unreasonably high. In that case, its underlyer, assuming a positive equity risk premium and
the results in the previous section hold. volatility risk premium for that underlyer in the long term.
However, a collar strategy is likely to outperform during
CONCLUDING THOUGHTS market downturns, owing to its lower equity exposure and
often its net long volatility exposure as well. Szado and
Reading a typical collar description can leave the Schneeweis [2010], for example, found that a passive collar
impression that the collar should have approximately strategy on the PowerShares QQQ exchange-traded fund
the same return as its underlying security: investors give (ETF) outperformed its underlyer from 1999 to 2009, a
up some upside so that they can reduce their down- period that included both the technology bubble collapse
and the financial crisis of 2007–2009.
side, and the net cost is zero because the call option 3
Although this particular collar implementation spends
premium collected is roughly equal to that paid for
more on puts than it collects from selling calls, we arrived
the put option. at very similar conclusions after simulating other portfolio
The truth is that a typical collar construction constructions that were closer to zero-cost. These results are
should be expected to have lower returns than its available upon request.
underlying security because (1) it has lower equity

Summer 2016 The Journal of a lTernaTive invesTmenTs

 4
The payoff diagram shown in Exhibit 1 is only appro- ——. “Who Should Use Equity Collars?” 2012b, https://
priate when the call and put option expire on the same date. www.cboe.com/strategies/pdf/equitycollarstrategy.pdf.
A collar strategy that buys a three-month put option at a
specific strike and then sequentially sells three monthly call Constantinides, G., and L. Lian. “The Supply and Demand
options at different strikes cannot be represented in a payoff of S&P 500 Put Options.” Working paper, NBER, 2015.
diagram because of path dependence.
5
It should be noted, however, that the put and Gârleanu, N., L.H. Pedersen, and A.M. Poteshman.
call option implied volatilities did not necessarily move “Demand-Based Option Pricing.” Review of Financial Studies,
in sync, both because the options had different strikes Vol. 22, No. 10 (2009), pp. 4259-4299.
and because they often had dif ferent expirations.
Therefore, the interpretation of the net vega exposure is Hill, J.M., V. Balasubramanian, K. Gregory, and I. Tierens.
somewhat complicated. “Finding Alpha via Covered Index Writing.” Financial
6
For this calculation, we considered a collar to be equiv- Analysts Journal, Vol. 62, No. 5 (2006), pp. 29-46.
alent to a protective put on a given day if the call option has
a delta exposure less than 0.02, a gamma exposure less than Israelov, R., and L.N. Nielsen. “Covered Calls Uncovered.”
0.2%, and a vega exposure less than 0.01%. Financial Analysts Journal, Vol. 71, No. 6 (2015a), pp. 44-57.
7
The strategy’s annual simple excess return is 2.9%.
Volatility drag reduces its compounded return to 2.3%. ——. “Still Not Cheap: Portfolio Protection in Calm
8
For this scenario, we assumed that all options’ implied Markets.” The Journal of Portfolio Management, Vol. 41, No. 4
volatilities spike to 150%, regardless of maturity. In an actual (2015b), pp. 108-120.
crash, however, the implied volatilities of longer-dated
options would probably not increase as much as shorter-dated Szado, E., and T. Schneeweis. “Loosening Your Collar—
options’ implied volatilities. Our simulation is therefore likely Alternative Implementations of QQQ Collars.” The Journal
being generous to the collar’s return in such an event, since of Trading, Vol. 5, No. 2 (2010), pp. 35-56.
applying a time-to-maturity adjustment to the collar’s put
option implied volatility shock size would decrease its simu-
lated return. Disclaimer
The views and opinions expressed herein are those of the authors and do
not necessarily ref lect the views of AQR Capital Management, LLC, its
REFERENCES affiliates, or its employees. This document does not represent valuation
judgments, investment advice, or research with respect to any financial
Bakshi, G., and N. Kapadia. “Delta-Hedged Gains and instrument, issuer, security, or sector that may be described or referenced
herein and does not represent a formal or official view of AQR.
the Negative Market Volatility Risk Premium.” Review of
Financial Studies, Vol. 16, No. 2 (2003), pp. 527-566.

Bollen, N.P.B., and R.E. Whaley. “Does Net Buying Pressure To order reprints of this article, please contact Dewey Palmieri
Affect the Shape of Implied Volatility Functions?” Journal of at dpalmieri@ iijournals.com or 212-224-3675.
Finance, Vol. 59, No. 2 (2004), pp. 711-753.

Chicago Board Options Exchange. “Equity Options

Strategies – Equity Collar.” 2012a, https://www.cboe.com/
strategies/equityoptions/equitycollars/part1.aspx.

r isk and r eTurn of equiTy index Collar sTraTegies summer 2016