While in attendance of a presentation on a new issue that implemented a reverse dispersion equity collar on an energy stock portfolio, it struck me that this type of product can fit nicely into sophisticated client portfolios, but the mechanics of the collar are a bit beyond the basic option trading strategy. In order to promote these types of funds to clients, an advisor may want to have a firm grounding in the underlying theory.
The reverse dispersion equity collar is a strategy to reduce the cost of portfolio insurance through two main mechanisms: Implementing an equity collar; and putting option pricing theory to work in our favour through reverse dispersion.
THE EQUITY COLLAR
First, let’s briefly look at the equity collar. If someone wants to protect their portfolio from loss without selling out the portfolio (for example, the investor has a large unrealized capital gain and only expects short-term market volatility), they can purchase put options. The put options gain in value, if the portfolio falls, and the gain on the puts offsets the loss on the portfolio.
However, purchasing a put option contract costs money. To reduce that cost to the investor, they can, in turn, sell call options. This gives someone else the option of buying away the portfolio if it hits the strike price. The investor will receive money for selling these call option contracts which can offset in part, or in whole, the cost of the portfolio insurance (the put options). What this does is to serve to limit the downside and upside of the portfolio’s performance for the length of the options – this is known as the equity collar.
REVERSE DISPERSION STRATEGY
In a nutshell, option pricing is heavily influenced by the volatility of the underlying security. Generally speaking, the more volatile the underlying security (or portfolio) the higher the price of the option since more volatility means more chance of the underlying asset hitting the strike price.
There are other variables that affect option pricing as well: Time – the longer the option contract, the more chance the underlying asset has to hit the strike price; Distance-to-Strike Price – the closer to the strike price the underlying asset is, the more it tends to be worth (since it is more likely to become in-the-money).
So here is the reverse dispersion strategy in motion using a basic example:
1. You buy put options on the entire portfolio with a one year term, that are perhaps 10% out of the money.
2. You sell call options on the separate stocks that make up the portfolio with one month terms, that are perhaps 5% out of the money, and keep rolling them over every month for the year.
A more concrete example, although more cumbersome, would be owning each of the stocks that make up the TSX/60, buying one-year put options that are 10% out of the money on the index and selling monthly 5% out of the money call options on each of the underlying 60 stocks, every month.
VOLATILITY = COSTS
The volatility of the TSX/60 as a portfolio of stocks is expected to be less than the volatility of any one constituent stock since at any time some of the 60 stocks are going up, and some are going down and some are not changing much. Since all 60 stocks are not perfectly positively correlated, the volatility of the portfolio is decreased. Since volatility is decreased, the put option on the entire portfolio as a whole costs less than buying put options on each individual portfolio constituent separately.
On the other hand, we are selling call options on each of the individual 60 constituents of the index, instead of selling call options on the entire index. Each of the constituent stocks separately are more volatile than the portfolio as a whole, hence the options are worth more. Also, note that the written calls are only 5% out of the money (the bought put was 10% out of the money). Since the strike price is closer to the stock price, this again would increase the price of the calls. Taken together, the income from writing the calls can be greater than the cost of the puts over the life of the strategy.
So to reiterate, we are planning to buy one set of put option contracts for one year which are 10% out of the money versus selling 720 sets of call option contracts (60 per month, for 12 months) which are each 5% out of the money. Using a lower strike price for the call options increases the income received with the tradeoff being the expectation of some stocks being called away from you on a regular basis. The frequency of this happening will vary with market volatility, but you can simply repurchase the stocks and write new calls whenever this happens. This means you will have some additional turnover in the portfolio, but it is possible to earn enough income from the calls to cover the cost of the puts over the life of the strategy. If you pick your spots, it is also possible to earn more income from the calls than you spend on the puts, known as a net-credit collar.
What would be a situation for considering this? Let’s say you have a client with a large enough portfolio that they can own at least 100 shares of all the stocks that make up the S&P TSX/60 index. Over time, you may have a large unrealized gain, and want to protect against a near-term correction, which could be severe, and still participate in any continued upswing. The reverse dispersion equity collar might be appealing as you are able to offer your sophisticated clients a strategy to limit their downside exposure while still providing a means to participate on the upside, albeit also in a limited capacity. Further, a portfolio manager who runs this strategy often tells me that the time and distanceto- strike differentials of the reverse dispersion can allow for the writing of call options on only half the number of shares owned of each of the constituent stocks in order to fully offset the cost of the put options. This means that only half the value of the portfolio is capped on the upside in the event of an across-the-board surprise rally.
It is worth noting that many reverse dispersion equity collars are implemented by institutional money managers using over-the-counter option contracts which are infinitely more customizable than exchangetraded options. The problem with trying to implement this is that Canadian exchange-traded options may not be liquid enough to provide desirable spreads.
Preet Banerjee, B.Sc., FMA, DMS is a Wealth Advisor with ScotiaMcLeod. The opinions stated are not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member CIPF. This strategy should only be considered by experienced, options-licensed advisors and only for sophisticated clients.