Collar,Hedge Article

This is an article from the February 20, 2006 Business Week Magazine on using options to reduce portfolio risk. I thought it was an interesting read to anyone that is interested in options.

FEBRUARY 20, 2006

Putting A Collar On Investment Risk
Options-based strategies can keep stock losses from getting out of line

Plenty of stock market shocks have underscored the need to protect your portfolio. Consider Google's (GOOG ) 7% drop on Feb. 1 or General Motors' (GM ) bankruptcy scare, which cut the price in half in recent months. Such losses can be hard to make up, especially if you're close to retirement. "You wouldn't think of not insuring your home," says Thomas J. Schwab, a founder of the investment firm Summit Portfolio Advisors. "But no one thinks about insurance when it comes to their investments."

Schwab (no relation to Charles) considers such insurance critical. With investors stung by the bear market of just a few years ago, Schwab, then a financial adviser at Smith Barney (C ) on the Hawaiian island of Maui, figured clients needed more protection against crushing losses. Looking at a myriad of strategies, he zoomed in on an options-based trade called a "collar" that uses a combination of puts and calls to keep losses and gains on a stock within a specific range.

Schwab's collar strategy is at the center of the advisory firm, which opened in September of last year and now has $7.5 million in assets under management. In fact, it has turned the typical portfolio management process upside down. Instead of choosing stocks first and then perhaps seeking options to protect them, he only chooses stocks on which he can place a low-cost collar that gives him at least twice as much potential gain as loss.

LIMITED POTENTIAL
Of course, investors could always protect against price declines in a stock by buying a put option alone and keeping the potential gains. That gives them the right but not the obligation to sell a stock at a particular price. But put options that will kick in near the current stock price are generally expensive. That's why managers like Schwab sell call options -- the obligation, in this case, to relinquish the stock at a preset price -- to offset the cost of the put. Done right, the total collar should cost less than $1.00 per share (before commissions), and can even net a credit.

The beauty of a collar is that you know, from the outset, the potential losses and gains on a trade. In a runaway bull market, your returns are likely to be somewhat muted because in selling a call, you've given up the right to appreciation beyond a certain price. But on the flip side, you'll have the comfort of knowing you're protected if the stock heads south. "We're a fan of collars for large portfolios, especially retirement accounts," says Kevin Lund, a strategist with Optionetics, a firm that gives options courses. "There is just no reason to incur much risk just for a potential gain."

Take Google, which was trading around 379 after lackluster earnings smacked the stock. Schwab recommends buying a 370 put that expires in January, 2008, which costs around $63.10 per share. Next, sell a 470 call with the same expiration date, collecting $64 per share. In all, that collar nets 90 cents a share. If the stock closes above 470, the gain on the investment will be 24.4% over the next two years, but the total loss would be only 2.1% should the stock drop below 370. "This is a stock that would scare me to death if I owned it outright," says Schwab. "With a collar, I can lower the risk."

Of course, commissions count. Even though costs have come down dramatically in recent years, trading options still tends to be pricier than buying a stock. Executing a collar strategy on 100 shares of Google, say, would cost $44.85 at the discount brokerage OptionsXpress (OXPS ), vs. $14.95 for just buying the stock. This strategy generally makes sense from a cost perspective if commissions lower your potential returns by no more than one percentage point.

For his clients, Schwab typically collars 8 to 15 large-company stocks, covering each major sector of the economy. He sticks with names that have options with an expiration date one to two years out, since he prefers to be a buy-and-hold investor rather than a trader. Potential collars can be found on his Web site (protectyourstock.com) and include scores of blue-chip companies like Apple Computer (AAPL ), General Electric (GE ), and Procter & Gamble (PG ). It's the same way he invests much of his own money.

Schwab got into the investing business by chance. As an undergrad at Notre Dame in the late '60s, Schwab interviewed with the New York Stock Exchange only as a favor to a professor. After spending a few years at the exchange auditing brokerage firms, he moved to Goldman Sachs (GS ) and later Smith Barney (C ) as a financial and pension consultant. Today investing is a family affair, with both his daughter, Liz, and his son, Joe, running the firm with him. "I wish I had been smart enough to use this strategy years ago," says Schwab. Investors can be smarter today.