This is a guest post by Philip Gocke, Managing Director for the Options Industry Council in Chicago, IL.

This summer’s fun has included the ongoing travails of financing the Greek debt, growing fears of downshifting economies in both the US and China, and political brinkmanship over the US debt limit. All of which have combined to keep investors from relaxing on the beach this summer. If you didn’t “sell in May and go away,” and would like to find a way to take a break in August and reduce market volatility caused by these and other contributing factors, then look for downside protection in the options market.

There are a variety of options strategies that can provide capital protection for equity based portfolios. The protective put and buy-write or covered call strategy are two of the most obvious choices for such option based approaches. However,  puts can be relatively expensive in periods of high volatility while covered call writing still leaves an investor exposed to large down moves.  So far the nervous sideward market movements have only modestly raised volatility risk levels, leaving them far below black swan proportions.  Thus investors are likely to be able to find some reasonably priced protection.

One strategy with downside protection features is the collar, in particular, a modified collar that was recently the subject of academic research at the University of Massachusetts.  Before we discuss how this strategy can be modified, here’s how the basic collar works.

A collar can be established by holding shares of an underlying security, purchasing a protective put and writing a covered call on that security. The underlying security may be a stock, an exchange-traded fund, a basket of stocks or an index.  Generally, the put and the call are both out-of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this spread are opening transactions, and are normally (not always) the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. (Source: Loosening Your Collar: Alternative Implementations of QQQ Collars). The collar strategy essentially adds a long protective put to a covered call strategy. This addition provides significant downside protection which the covered call lacks. The purchase of the long put is financed by the sale of the call. In essence, the collar trades upside participation for down-side protection.

Source: Loosening Your Collar: Alternative Implementations of QQQ Collars

A modified collar strategy has been researched by Edward Szado & Thomas Schneeweis of the University of Massachusetts in their paper, Loosening your Collar: Alternative Implementations of QQQ Collars (www.optionsEducation.org/institutional ).  The modified collar strategy was back tested over a 138 month period ending in September 2010.   A standard collar commonly employs the same maturity for the put purchase and call write (as diagramed above).   However the authors found that a long protective collar using 6 month put purchases & consecutive one month call writes earned far superior returns compared to a simple buy-&-hold of the PowerShares QQQ ETF while reducing risk by 60%. By purchasing the downside protection only twice a year the negative impact of time decay is reduced.  Meanwhile the frequent call writes increase the benefit of time decay on the other half of the strategy.

We can all hope that a little protection from the summer’s heat is all that is needed and the only cost is being encumbered with a large umbrella to protect against those unexpected summer thunderstorms. If investors take advantage of risk management strategies, they may be more inclined to shake off their fears and put their zero yielding cash to work in the equity market.  They might also be positioned to participate in a possible relief rally as the sweat inducing economic and political issues gradually are resolved.

www.optionseducation.org/institutional/research/qqqq.jsp .

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.