Grab risk by the collar

It’s late April 2010 and the first details of an explosion at BPs Deepwater Horizon rig in the Gulf of Mexico hits the tape. BP is trading at approximately $60.50.

As a portfolio manager, you understand that this is not a diversifiable risk albeit the position may be part of a diversified portfolio.

What to do? Wait?

By early May, BP is trading at $50 and as various attempts to stop the leak fails, the stock continues to drift lower. By late June, BP trades at $27.50.

Since then, it has rebounded to the $40 range but the question to have asked at the outset was – is there a strategy that could have managed the risk in an effective manner?

For a portfolio manager this type of situation becomes critically important when considered within the context of fund performance, absolute or relative, or if a sector bet had been established.

Your alternatives:

• (1) Sell the position
• (2) Hold on for better or worse
• (3) Buy protection via a put option,
• (4) Buy a collar.

Let us focus on the collar alternative for a minute. What is a collar?

A collar is the simultaneous purchase of a put option and the sale of a call option both maturing at the same expiration date. The sale of the call option (and a stock’s potential upside) finances the purchase of the put option (the protection to the downside).

Given market parameters, it may be structured to be costless to the buyer and consequently called a zero-cost collar. In effect, one can indicate at what level the protection is desired (i.e. the put) and the sale of the call option (i.e. the upside) is then determined in order to make the strategy costless (or vice-versa).

There were two major considerations in this situation, the elevating volatility and BPs dividend yield.

Firstly, volatility became increasingly elevated as the days and weeks went by as the situation worsened. Secondly, BPs attractive dividend yield (before its cut) cushioned the expected cost of the strategy.

The only consideration left was which maturity date to select. One month, three, or six months?

Once again, a few considerations, first, cost in terms of volatility and second, expected risk horizon. Not unexpectedly, in early May, the volatility for one-month options was higher than that for three-months (and three-month higher than six month) and it appeared that this situation was not going away anytime soon.

Strategy

Purchase a five-month collar as the situation was not improving; the risk appeared to be to the downside and therefore volatility was expected to increase. The fat dividend would cushion the cost of the more expensive puts, and by going out five months, the cost in terms of volatility, would be reduced further.

With BP closing at $50.99 on May 5, 2010, a five-month zero-cost collar (Oct ’10 listed expiry) would have the put option strike at $49 and the call option strike set at $52.50.

Paying a small premium of $1.25 would allow for the call option to be struck at $55, however, BP would have to drop below $47.75 for the strategy to be most effective.

As noted earlier, BP traded to the $27.50 area in June. It has rebounded since then, but at that moment in time one would not have know this. Exercising the put would have allowed for a “defined” exit level of $48 and, more importantly, access to funds that could have been deployed into a more productive and/or desirable position.

Conclusion

One can say that hindsight can be 50/50. However, strategies, such as the collar, are applicable given an understanding of the parameters and the situation of when to apply them. This is where the “art” of risk management is as integral as its “science”.

Pascal Bancheri, CFA, is the president and principal of Sigma Management Advisors Inc.