When To Hedge With Puts Versus Collars

Still image from TikTok user @robinhoodkid's video explaining call options. Short call options are one leg of a collar. 

Puts Versus Collars: When To Use Which

We've developed a simple quantitative approach to determine when to hedge with collars or puts in a portfolio. If you know what puts and collars are, you can skip the next section. If not, let's start with a quick refresher. 

Puts, Calls, And Collars

Puts: Put options give an investor the right, but not the obligation, to sell a particular security at a specified price, on or before a certain date.

Calls: A call option is the opposite of a put option: it gives an investor the right, but not the obligation, to buy a particular security at a specified price, on or before a certain date.

Collars: A collar is a strategy that pairs buying a protective put option on a stock or ETF with selling a call option on the same security. By selling a call option, you give an investor the right to buy your stock or ETF if it appreciates beyond a certain level, and obligate yourself to deliver the stock or ETF if the option is exercised; in this way, you cap your potential upside. In return, you get paid by the buyer of the call option. The income you get from selling the call option offsets some of the cost of buying the protective put option. So your net cost in opening a collar will lower than the cost of just buying a protective put.

How We Determine When To Hedge With Puts Or Collars

First, we test if it's possible to hedge the security in question both ways. Depending on the drawdown you're willing to risk, it may not be.

If it is possible to hedge the security both ways, we scan for the optimal, or at least expensive, version of both types of hedges, and note their respective costs. The optimal collar will always have a lower cost than the optimal put hedge, but there's another factor to consider beyond hedging cost. We call it the put preference factor.

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