Webinar for CFP CE Credit Collars as a Bond Alternative*

Transcription

1 Webinar for CFP CE Credit Collars as a Bond Alternative* Thomas J. Schwab, Chief Investment Officer Summit Portfolio Advisors, LLC Pioneers in Collar Investing For Professional Use Only *This course updates and replaces previous CFP course titled Risk Management with Collar Investing

2 What is a Stock Collar? A Stock Collar is the purchase of both a stock and put option, along with the sale of a covered call option; the long put limits the downside risk of the stock while the covered call limits the stock s upside potential, but also offsets the cost of the put. While the stock is wrapped in a collar, any loss or gain is limited to the minimum and maximum range of the collar, no matter how much the stock actually falls or rises. Why protective put options might be preferred to using stop loss orders. Stops do not always protect you when a stock gaps down. Stops can cause whipsaw. 1

3 What is Collar Investing? Collar Investing searches for those stock and collar combinations that offer the most attractive reward to risk opportunities. Collar Investing has nothing to do with concentrated stock positions. The primary purpose of collaring a concentrated stock is to protect the stock investment without selling it. With Collar Investing, the primary objective is to achieve attractive returns with minimal risk. 2

4 A Collar Investing Example: Option Skew is Primary Driver for Stock Selection Assume: A stock trades at $100 (and pays no dividends) The stock s $90 strike put option trades at $6 The stock s $110 strike call option trades at $8 Why do we find this collar attractive? Both the put and call strike are $10 out of the money, but the call is trading at $8 and the put is trading at $6. The call is richer than the put which indicates one of two possibilities A) option investors are bullish on the stock (positive momentum stock). B) the stock has fallen and unlikely to fall much further (out of favor stock) Also, the collar s upside potential is greater than the downside risk. Buy stock at $100 plus $6 put, minus $8 call=$98 net cost. Upside potential = +$12 ($110 minus $98) Downside risk = -$8 ($90 minus $98) 3

5 Collars vs. buying protective puts or selling covered call strategies Assume buy stock A at $100 Protective Put: Buy $90 1yr Put trades at $6 Covered Call: Sell $110 1yr Call trades at $8 Buy Protective Puts Strategy Covered Call Strategy Collar Strategy A drops to $50 $16 loss $42 loss $8 loss A stays at $100 $6 loss $8 gain $2 gain A rises to $150 $44 gain $18 gain $12 gain Comments Puts only strategy will erode returns Calls only limits gains but still risky Reasonable upside with limited risk Prof. Robert Dubil 20 year study comparing collars, protective puts only and covered call option hedging strategies: Collars offer the best risk reduction and return-to-risk reward of all the tested strategies. Journal of Financial Planning, May 2010 issue 4

6 Types of Collars: Example ZC, ATM & ITM on $65 stock Long Put Strike Covered Call Strike Collar Cost/ (Credit) Max Risk % Max Reward % Zero Cost (ZC) $60.00 $72.50 $ % 11.3% At-the-money Call (ATM) $57.50 $65.00 ($4.00) 5.8% 6.5% In-the-money Call (ITM) $52.50 $60.00 ($8.60) 7.1% 6.2% Zero Cost Collars: Greatest upside potential, but gains entirely dependent on stock appreciation above $65 at collar expiration. At-the-money Call Collars: Collar has maximum gains even if stock is unchanged at $65 at collar expiration. In-the-money Call Collars: Collar has maximum gains even if stock has dropped to $60 at collar expiration. Which collar to select?? Depends on near term outlook for underlying stocks. 5

7 Collars as a bond alternative An equity strategy with bond-like volatility. Collars monthly standard deviation historically is about 1/4 th the S&P 500 and slightly higher than AGG. Low Default risk: Listed options backed by OCC. S&P rate OCC same as US Sovereign debt. Bond-like volatility but near-zero or negative correlation to bonds Collars may fare better than bonds if interest rates rise. Collars vs. Stock and Bond expected returns: JFSP article by Prof. D Antonio, PhD Collar expected returns = 52%/48% S&P 500/5 yr. Treas. Morningstar 11/20/09 report should outperform bonds with similar risk 6

8 Collar Investing as alternative to equityindexed annuities and equity-linked notes Reasons why Collar Investing may be better than other protective products. Greater transparency Greater liquidity Lower Counter-Party Risk With collars, you get the dividend Perhaps more favorable risk/reward for investors Bullish option skew stock create more attractive risk/reward equations than collaring an index. 7

9 Collars vs. Absolute Return Alternatives Morningstar classifies collar investing as a long/short alternative strategy. Absolute Return Alternatives hedge risk by being long or short stocks. Example: A pairing strategy (long GM, short F) Absolute Return funds eliminate beta as a source of returns. Positive returns come only from manager skill. Absolute funds often charge 2% or more (see Unappealing Alternatives Financial Planning Nov 2012 article.) Collars hedge risk through buying a protective put and selling a covered call. Positive returns come from net call premium credits and stock appreciation. 90% correlated to stocks Historically, wind is at our back about 3 out of 4 years. 8

10 Collar Investing Suitability Baby Boomers and retirees who can t take much risk. Use as an equity supplement. Provides equity exposure at less risk. Long term investors such as Pension Plans, Foundations, and Endowment Funds Use as a bond alternative. Investors worried about total market collapse. A contingency disaster component in their asset allocation mix. Caveat: Collar investing may not be tax-efficient. Tax sheltered accounts (IRA rollover, etc.) may be preferred. 9

11 Where does Collar Investing fit? The asset allocation mix Bond Managers Collar Investing Portfolio Equity Managers Collar Investing as Bond Alternative For Long term investors who do not need current income from bonds. Pension plans? Younger investors? Collar Investing as Equity Supplement For investors seeking equity exposure with limited risk. Retirees and Baby Boomers? Nervous Investors? 10

12 Collars versus Asset Allocation In 2008, asset allocation did not adequately hedge risk. Why Asset Allocation is Failing article: Non-equity assets correlate 35% in strong up markets and 85% in sharply down markets. i.e. REITs do not correlate the same in normal and extreme markets. Assume client requests max loss of 10%. If using asset allocation, past experience would require 18%/82% stock/5yr treasuries allocation (based on 1931). No assurance that 1931 is worst case scenario. Collars provide absolute certainty of downside risk. Adding Collar Investing to the asset allocation mix should facilitate better risk management for the overall portfolio. 11

13 Collars are a New Asset Class Collars produces an unusual combination of high equity correlation with bond-like volatility. Collars change the timing of distributions. Example: $100 stock with $90 strike put and $110 strike call. If stock rises immediately to $110, part of the $10 stock gain is delayed. Collars for Crisis Management Some new asset classes may lose liquidity in turbulent market environments Collars don t require trading in panic markets (i.e. portfolio insurance Oct 87) 12

14 Sample Portfolio of Stocks Protected with Equity Collars (as of 1/15/08 10:39 AM NY time)* For investors seeking protection (i.e. portfolio insurance), the equity collar can be an effective and inexpensive way to limit risk in the stock market. This hedging tool places boundaries (or a collar) around a stock with listed options; a Put option is bought to limit risk (the lower boundary), and a Call option is sold to reduce costs (the upper boundary). While a stock is wrapped in the collar (such as for one or two years), any loss or gain is limited by the minimum and maximum price range of the collar, no matter how much the stock actually falls or rises. Generally, a collar is most attractive when potential gains under the collar substantially exceed potential losses, such as in the hypothetical portfolio of collared stocks listed below. Summit Portfolio Advisors, LLC has pioneered Collar Investing, which allows stock investment within a pre-determined range of risk and reward. The special features of this conservative investment approach are highlighted in these collar investing examples. For more information about Summit s investment management services ($100,000 minimum account size with annual fee normally 0.80%), click on Advantages: Considerations: -Limits risk of owning stocks -Limits maximum return -Portfolio Insurance at minimal or no cost -Tax rules for hedging may apply Collar as of: 1/15/08 10:39 AM Buy Stock at (Ask Price): Collar: Put exercise price (Lower Boundary): Call exercise price (Upper Boundary): Put and Call options expire on: Days to expiration: AAPL $ $ $ /16/ CMI $49.27 $45.00 $ /16/ CTSH $27.47 $25.00 $ /16/ JCP $36.45 $35.00 $ /17/ MYGN $47.39 $45.00 $ /17/ OMC $43.75 $40.00 $ /16/ QCOM $39.01 $35.00 $ /16/ RIMM $92.80 $90.00 $ /17/ SPY $ $ $ /20/ WFMI $36.40 $35.00 $ /17/ Equity Collar Calculations: Collar: Buy Put Option at (Ask Price): Sell Call Option at (Bid Price): Net Collar Cost (Credit): Less: Dividends assumed until expiration: Stock Breakeven at Expiration: $ $ $1.35 $0.00 $ $9.70 -$9.30 $0.40 -$2.00 $47.67 $4.80 -$4.90 -$0.10 $0.00 $27.37 $6.20 -$5.70 $0.50 -$0.80 $36.15 $8.60 -$8.60 $0.00 $0.00 $47.39 $5.00 -$4.10 $0.90 -$1.20 $43.45 $5.70 -$6.30 -$0.60 -$1.12 $37.29 $ $19.70 $0.00 $0.00 $92.80 $7.00 -$7.65 -$0.65 -$3.10 $ $5.40 -$4.80 $0.60 -$0.80 $36.20 Upside per share (Call Exercised): Risk per share (Put Exercised): $ $4.70 $ $2.67 $7.63 -$2.37 $3.85 -$1.15 $7.61 -$2.39 $ $3.45 $7.71 -$2.29 $ $2.80 $ $9.93 $3.80 -$1.20 % Gain for period (Call exercised): % Risk for period (Put Exercised): 20.2% -2.7% 24.8% -5.4% 27.9% -8.7% 10.4% -3.1% 16.1% -5.0% 25.9% -7.7% 20.1% -6.0% 11.4% -3.0% 10.9% -7.2% 10.3% -3.2% % Annualized Gain (Call exercised): % Annualized Loss (Put Exercised): 10.1% -1.4% 12.4% -2.7% 13.9% -4.3% 10.3% -3.1% 16.0% -5.0% 12.9% -3.8% 10.0% -3.0% 11.3% -3.0% 11.7% -7.7% 10.2% -3.2% Reward/Risk Ratio: 7.5 to to to to to to to to to to 1 Caution: The above information is derived from raw data provided by our vendors. Though generally reliable, Summit Portfolio Advisors, LLC makes no assurances as to the accuracy of this information. * Where dividends are included, they are assumed to be collected at the current dividend rate until option expirations. Also, no commissions, fees or other costs have been included in these calculations, which are for demonstration purposes only. In addition, different assumptions will lead to different results. This example was prepared by Summit Portfolio Advisors, LLC ( SPA ). It is intended to show how SPA may use an equity collar on particular stocks. The given materials are subject to change and, although based upon information that SPA considers reliable, are not guaranteed as to accuracy or completeness. This information is for educational purposes only. Neither this example nor any information derived from using this example constitutes tax, legal or accounting advice or an offer to buy or sell any security or other financial instrument. Neither this example nor any information derived from using this example should be the primary basis for any investment decision, and any such information is not guaranteed to be accurate or complete or applicable to your circumstances. Options and other financial derivative instruments involve certain risks and are not suitable for all investors. Hedging strategies may be subject to IRS Tax Straddle regulations and other IRS rules, which might adversely impact tax treatment in your specific situation. You should consult your legal, tax and accounting advisors for assistance in analyzing your circumstances to determine how these transactions may impact you. For information on the uses and risks of options, you can obtain a copy of Characteristics and Risks of Standardized Options from the Option Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606, OPTIONS. Nothing in this example should be interpreted to state or imply that past results are an indication of future performance. Neither SPA nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the user. SPA is not affiliated with any of the companies in this sample portfolio and the information presented has not been reviewed or endorsed by any of these companies. Summit Portfolio Advisors, LLC PO Box 837, Denver, CO Tel: (toll free) or Fax: info@summitportfolioadvisors.com Web: Summit Portfolio Advisors, LLC 13

15 Collaring the S&P A Recent Example SPY Collar Example as of October 9, 2:46 PM EDT: Buy 100 shares $ $19, Buy 1 SPY $175 Put Expiring ($8.27 per share) $ Sell 1 SPY $215 Call Expiring ($2.76 per share) $ Net Collar Cost $ Less: Estimated Dividends for 356 Days $(368.00) Breakeven Cost on * $19, Proceeds if Put Exercised on at $175 $17, Net Loss $(2,001.00) % Loss for 356 Days -10.3% Proceeds if Call Exercised on at $215 $21, Net Gain $1, % Gain for 356 Days +10.3% *Note: No commissions, fees, or other costs are included in these calculations which are for demonstration purposes only. This trade was not actually executed but reflected bid and ask prices that were available at a moment in time. There is no guarantee that this trade could have been executed at these prices. 14

16 Exam choose the false answer. 1. Asset allocation: A: Was highly effective as a risk management tool during the 2008 market crash, B: Is used by many advisors as a risk management tool, C: Is one way to manage portfolio risk. 2. Collar Investing most appropriate for: A: Aggressive investors, B: Conservative investors, C: Baby Boomers and retirees 3. Collar Investing generally has: A: Low correlation to equities, B: High correlation to equities, C: Low correlation to bonds. 4. Collar Investing is most suitable in: A: Taxable accounts, B: Non-taxable accounts, C: IRA rollover accounts. 5. A zero cost collar means: A: No commissions are charged, B: The put and call premiums offset each other, C: the collar s net cost is minimal. 6. A stop loss order: A: Ensures sale of a stock at a certain price, B: Is intended to limit downside risk, C: Can automatically trigger a stock sale. 7. In a strong up market, Collar Investing will: A: Out-perform the market, B: Under-perform the market, C: Usually provide a positive return. 8. With Collar Investing: A. You will never lose money, B: You can lose money, C: Any gain or loss is largely dependent on the collared stocks rising or falling. 9. Collar Investing is considered: A: A high beta strategy, B: a low beta strategy, C: A low volatility strategy. 10. A portfolio with options: A: Is always riskier than stocks alone, B: Is sometimes less risky than a stock only portfolio, C: Can sometimes help manage the portfolio s risk. 15

17 How to Receive CE Credit For CE Credit, the following to: First, Middle, Last Name Your CFP Registration ID Exam Results We will report your attendance to the CFP Board and confirm your attendance in a reply to you. Thank you (mahalo) and wishing you a warm aloha. Tom Schwab 16