When To Hedge With Puts Versus Collars

The put preference factor quantifies an empirical phenomenon we've observed over years of tracking tens of thousands of positions: the gross returns (i.e., not subtracting hedging costs) of securities hedged with puts are, on average, significantly higher than those hedged against the same declines with collars

Doesn't That Depend On Where You Cap The Collars?

Actually, no. There's a limit to how high you can set the upside cap on a collar. There have to be bids on calls that far out of the money, and they have to be high enough to offset enough of the cost of the put leg to make the hedge reasonable. It would be unreasonable to pay, say, 15% of position value to hedge against a 10% decline, for example. And if you collar enough stocks or ETFs, over time, some of them will rise far above your upside caps. With collars, you won't capture the excess returns of those positive outliers; you will with optimal puts because they are uncapped. We quantify the put preference factor - the extent to which the gross returns of positions hedged with puts outperform those of positions hedged with collars - and update that figure every trading day. Currently, it's approximately 1.8, meaning that, on average, security hedged with optimal puts will have a gross return 1.8x that of the same security hedged with an optimal collar. 

Applying The Put Preference Factor

For simplicity's sake, let's consider two possible hedges against the same drawdown:

  1. An optimal collar capped at a security's estimated potential return. 
  2. An optimal put hedge. 

When we construct hedged portfolios, we test optimal collars capped at a few other levels as well, but the two possible hedges above are sufficient to show how we apply the put preference factor. For the position hedged with the optimal collar, we simply take the estimated potential return and subtract the hedging cost. We call this the net potential return (the potential return net of hedging cost). 

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