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Options Strategies for the Passive Investor

As regular readers will know, I’m a proponent of a very simple buy & hold, passive investing strategy. However, I do believe that there’s a value to discussing and understanding alternative strategies so that you can decide whether they’re appropriate for you. That’s why I recently invited Mark Wolfinger, author of Options for Rookies to write a guest post. He was kind enough to oblige.

Option strategies, specifically the collar strategy, can provide additional safety for your portfolio. That means a guarantee against incurring significant losses (you decide how much loss you are willing to accept–much like the deductible on an insurance policy). No asset allocation program comes with guarantees. They may come with high probability of fulfilling your needs, but that’s not as good as a guarantee.

Many of you have a negative feeling towards options and that’s understandable considering how much bad press options (or any derivative product) have received. The truth is that options were created as hedging (risk reducing) tools, and if more investors used them for that purpose, options would have a better reputation.

My specific objective today is to share why I believe passive investors can benefit by using options. General option education is available elsewhere.

There’s more to investing than choosing between passive and active management. For example, the Prudent Man Rule tells us that asset allocation and diversification are vital to reducing risk. But, the recent (technology bubble and 2008) market meltdowns have convinced many that these methods only work in bull markets.

A recent WSJ article discusses how a bunch of financial advisors have been shaken by a failure of ‘prudent’ measures. Another article tells how some advisors abandoned their traditional ideas and are now making (in my opinion) extraordinary investment decisions–in a desperate attempt to succeed. These advisors have abandoned passive investing. I’d never suggest that you do the same, but there are steps you can take to make your portfolio bulletproof. Of course, that excellent protection comes at a cost, and that cost is accepting limited profit potential and giving up the possibility of earning a substantial sum in a hurry. You still have room for growth, but it is limited.

The difficult part of investing is to find methods that provide relatively good results when markets are falling. That does not mean losing 30% when everyone else is losing 40%. It means not incurring any large losses. Ever. For the majority of investors, preventing occasional large losses is impossible and the question is: Are you confident that owning a properly diversified portfolio with assets appropriately allocated is good enough? Do you believe you are protected and can survive during bear markets, or would you prefer to own the necessary protection, knowing that your portfolio will underperform when markets are marching steadily higher?

If you are uncertain and concerned that years similar to 2008 will occur with more frequency going forward, option strategies can alleviate that concern. My host, Mike, says that good asset allocation worked last year, minimizing losses. I have no idea how well diversified portfolios performed, but the WSJ articles quoted above suggest that asset allocation did not do the job. How well did you do?

Here’s what I suggest: Continue asset allocation and diversification. But take out insurance when possible. As I explained in a recent post, owning collars underperforms significantly in bull markets and outperforms just as significantly during declining markets. (For reference, Mike’s counter-argument can be found here.)

Using collars protects your investments from serious losses. It also limits profits.  Collars provide a smoother ride because the portfolio value is less volatile. Again, options are not for everyone, but insuring the value of your equity and commodity holdings by adopting a collar strategy guarantees long-term survival.  Failure to use options shows a willingness to be satisfied with the (current) advice given to the Prudent Investor. Which is right for you?

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  1. Mr. Wolfinger:

    I’ve been reading the discussions here with some interest, although I think your strategy is likely not for me. I took a look at your link to the examination of the collar strategy’s hypothetical past performance as well. I have a few observations that are really also questions:

    1. Does this strategy really call for purchasing options every third Friday of the month? Moreover, does it include commission costs? Not only does this add complexity (and likely more trading cost based on the frequency), it would be quite a hassle. Is there an easier way to implement the strategy that would not require such frequent options trading?

    2. Your data is based on the S&P 500, which is merely one asset. Would you have to purchase options with respect to every asset class held in your portfolio for the strategy to be effective? If so, it again seems that this would multiply trading costs and create more hassle.

    3. Finally, your data also doesn’t indicate whether the collar strategy is more effective (after costs) than simply pursuing a diversified portfolio and rebalancing at regular intervals, which also reduces volatility in a portfolio.

    It seems to me that pursuing the collar strategy is a good bit of work to reduce risk that could be achieved, as Mike says, with a higher fixed income allocation. More over, if you include rebalancing over time, it seems like any benefit from the collar strategy would be further reduced. This is probably a better strategy than some of the loss-limiting products companies are selling today, but I wouldn’t believe that traditional diversification is dead because a few advisers – paid for expected outperformance – have declared it so.


  2. First off, asset allocation did not fail. Perhaps specific allocations failed specific investors, but that is likely caused by an inappropriate allocation and not asset allocation in and of itself. The purpose of asset allocation is not to prevent any losses from occurring; however, investors can sill incorporate allocations that will guarantee against incurring losses or a chosen level of loss over specified periods of time. Just like options, it’s risk vs. reward, and investors can decide how much loss they are willing to accept using asset allocation.

    Whatever way you try to spin it, options have a cost. Even with a zero cost collar, while nothing is spent out of pocket, limiting you up-side may mean less money in your pocket in the future. That is a real cost. Furthermore, unless you can regularly and properly exploit pricing inefficiencies in the options market, you will be paying additional net costs just to transact. Anyone can sell something for $10 and buy something else for $10 without opening their wallet, but the thing you just bought isn’t necessarily worth as much as the thing you just sold. Participating in the options market isn’t free.

    When deciding if a cost is worthwhile, I like to consider the value of the benefits. Your claims that the insurance provided is beneficial are not entirely relevant benefits. I could see why such strategies may be considered in periods of time when investors will need to sell assets to meet cash needs and can’t chance bad market pricing. But I do not see the point of trading away up-side to protect against market declines if you’re not planning on selling during that same period of time. I don’t care that the value of my house went down because I’m not planning to sell it to anyone anytime soon.

    Your proposition sounds a lot like buying travel insurance for a trip that you’re not even planning. And to do that over and over again, that sounds like a colossal waste of money to me. Your post seems to appeal to the psychological benefits of investors, that they will feel better, more confident having insurance even they don’t need it. Once you actually realize you don’t need it, do you honestly think the realization that you are paying unnecessary costs will be beneficial?

    You are right that options are not for everyone; just like travel insurance isn’t for everyone. Only those with a trip planned during the covered period should even be considering it!

    Here’s what I suggest: Continue asset allocation and diversification. But take out insurance only when you actually need to insure something against a loss.

    Oh, and lastly, Mark, did you read those entire articles, or just the parts that support your case?

  3. Hello JF,

    If course, this strategy is not for everyone. It’s not for those who have a VERY bullish outlook and want to earn the maximum possible profit in the years ahead.

    1) You don’t have to trade monthly. The “95-110” strategy followed by the CLL index requires buying a put every 3 months and selling a call every month. But there is no reason to adopt that timing method. Collars can be traded with a variety of expiration dates. Most common would be quarterly. But you can buy and sell options that expire every January. That would be once per year – after the initial trade.

    No. Commissions are not included. But these days, you can buy and sell options for $1 per contract, with no additional charges. True, if you use a full service broker, or even one like Fidelity or Schwab, commissions are not to be ignored.

    If you find the occasional entering of orders to be a hassle, there’s not much I can say. The same goes for complexity. That is really something that is in the eyes of the investor. Anything difficult to understand is going to feel ‘complex.’ If you ‘get it’ quickly, then it’s going to be simple. But, even if ‘simple,’ it may remain a hassle. That’s the decision you must make for yourself – deciding how much is that hassle worth and are you willing to do it. For me, it’s fun. I love trading. But, I’m not a passive investor.

    Keep in mind that I’m NOT saying passive is terrible and you MUST find another method. I’m saying it is a bit more risky than most people see, and – for a price (reduced profits most years) – you can get a guarantee of no significant losses. It’s a trade-off. You like that idea or you don’t. Over the pasts 21 years, the strategies (collar vs no collar) have performed on a par. The extra safety didn’t cost much. The future? I surely don’t know.

    2) Yes, each investment requires it’s own collar. But, as a compromise you can adopt this strategy ONLY for yous stock market investments.

    I’d also collar commodities, but it involves more trading.

    I have no way of obtaining data for that. All I can do is show that for a passive stock market investment, the collar does what it does.

    Mike pointed out that a 50/50 portfolio divided between stocks and some specific type of bonds performed about the same as the collar over the same 21-year period – with much less hassle.

    But there is the argument made in one of those WSJ articles, that with so many people adopting passive methods and asset allocation, when it hits the fan, panic can result in all assets coming under attack. That is the one aspect of asset allocation that that has been NOT considered – at least in my opinion: That it’s very popularity makes it less effective.

    It’s a different world today and diversification is just not as effective as it once was – because a panic sell-off is possible in all (ok, most) assets simultaneously. The question is: are you satisfied with asset allocation as a risk-reducing method, or do you want to bother with the ‘hassle’ of learning more about options and understanding how they work – and then making the necessary trades?

    I wish I could tell you that making this effort is worth $X so you can decide if it’s worth it. But I cannot. I don’t know how anyone would allocate assets nor how much would be in the stock market at any given time. Nor how the other assets would perform. To keep things very simple, just consider collars to be insurance policies – and insurance is costly. Collars cost nothing in cash – but they cost in possible opportunity lost. Is it worth it for you? I have no way of knowing.

    3) Yes, I have no ‘re-balancing data.’ It’s impossible. Who is to decide how much the re-balancing will be. Is it 60/40 this year and perhaps 59/41 next year? This data cannot be collected. Or it it can, I cannot do it nor am I willing to pay the huge costs of obtaining all the needed data.

    But you can make the attempt. The CBOE shows annual results for CLL vs SPTR. ( So, you can mentally re-balance every year over the past 20 years and use the data for the collar portion. I have no idea how you will get the data for the non-stock portion. Maybe you can use your actual investing results – if you have enough data.

    My argument is simply this: Collars have been very inexpensive as insurance policies over the time period for which data is available. Any investor who is concerned about more frequent bear markets can have a guaranteed portfolio value with collars.

    Anyone who is very bullish is better off with no collars and the ability to prosper when markets surge.

    Passive investors, who should have no opinion on market direction, must decide between oblivious investing, passive investing with almost no tinkering, or taking the time to protect the value of a passive portfolio. There is no single best answer that suits everyone.

    4) I agree that traditional diversification is NOT dead for the reason stated. But is it mortally wounded because so many more people – the majority of whom are subject to panic – can decide to dump all investments at the same time? Your not panicking doesn’t protect your assets when those around you sell in panic.

    I don’t know the answer. I’m trying to get people interested in this idea. Obviously there is no ‘obvious’ correct answer. If you have confidence that your methods are going to work for you in the future, and if you believe there is very little extra risk in not owning a guarantee, then there is no need to change. I am NOT suggesting that it’s foolish to depend on the old tried and true methods – for I really don’t know what the future holds.

    Just remember that higher fixed income allocation also diminishes returns when we are in a bullish market – and may not be the best solution for you.

    Thank you

  4. Dylan,

    1) “First off, asset allocation did not fail”

    I don’t know that to be true or untrue. Some people believe it failed. I clearly do not know how well-informed they are, whether they have their facts straight, or are just making it up to have a story to tell. I do understand that you have an interest in believing that your statement is true. It allows you to sleep at night with your portfolio. That’s very good for you. Congratulations.

    2) “investors can sill incorporate allocations that will guarantee against incurring losses or a chosen level of loss over specified periods of time.”

    How do you do that? Please do not recite past history which is not proof. So I ask, why do you say that a guarantee exists? I’ like to learn.

    3) “limiting you up-side may mean less money in your pocket in the future. That is a real cost.”

    No one suggested otherwise. But when you move into less stock/ more bonds (for example), you also limit your upside and have just the same opportunity cost.

    In fact Mike’s comment that a 50/50 stock/bond allocation performs about the same as collars, tells exactly that story. ‘Protection’ via asset allocation has its own costs. Are you ignoring those costs?

    4) “Participating in the options market isn’t free.”

    Never said it was. I say, over and over, that insurance is not free. There is a cost. I am willing tp pay that cost for a guarantee of safely. If you are not, so be it. Options are not for everyone.

    5) “But I do not see the point of trading away up-side to protect against market declines if you’re not planning on selling during that same period of time. I don’t care that the value of my house went down because I’m not planning to sell it to anyone anytime soon.”

    This is the same argument you and I have had before. You don’t think you have a loss when your assets decline in value. I don’t believe I can converse with someone who doesn’t know when he has a loss.

    But, the fact that you do not have any plans to sell changes nothing. If people have no plans to sell, they why is ‘everyone’ crying over their ‘pretend’ losses? Why do people feel less wealthy? Why are they spending less? Why are retail stores hurting?

    Answers: Because people ARE less wealthy. Because they have less money. Because they own less valuable assets. You may not feel that you have a loss (if you lost account value), but almost everyone else does and feels the pain.

    But here’s the real question: Why are you willing to ‘trade away upside’ to allocate assets out of the stock market but are not willing to trade away the upside to buy collars? What’s the difference?

    If you believe you will never see another bear market, then by all means, go for it. Get long, stay long and grow wealthier. I’m rooting for you.

    Speaking for myself, I want insurance and I want others to be aware that such insurance is available.

    Considering collars, and then rejecting them, means investors have open minds and are looking for better ways to have a successful financial future. Refusal to consider alternatives to one’s current methods is not a good idea. You never know what you don’t know until you make an effort to learn.

    6) “Your post seems to appeal to the psychological benefits of investors, that they will feel better, more confident having insurance even they don’t need it”

    Don’t need it? Says who? Who are you to tell people they don’t need it? Ask the millions of people who feel very poor right now if they would have bought portfolio insurance if they had known it existed.

    Ask the owners of all those 401k plans that were decimated last year.

    Of course they need it. How can you possibly suggest they don’t. You just choose to get it via asset allocation and diversification. But, it’s still insurance – but not guaranteed.

    And don’t knock the benefits of ‘feeling secure’ and being within a comfort zone. It is very beneficial and I believe people should invest to be satisfied with what they own, and not worried. Collars provide that safety net. If you believe asset allocation provides that same safety net, then you have your comfort zone. Allow others to find theirs – I encourage every investor to find his/her own zone.

    7) “Oh, and lastly, Mark, did you read those entire articles, or just the parts that support your case?”

    I read all. I have an open mind. I see benefits to adopting collars that you cannot.

    That’s works for you. You are in your comfort zone of bliss.

    But there is no need to offer the insult that suggests I dug out what I needed from those articles. Did you want me to quote the entire articles?

    Why don’t you read them and dig out evidence that supports your views?


  5. I’m sorry, but I’m closing comments on this thread. I feel that the topic itself is worthy of discussion, but I don’t feel any desire to moderate a battle of personal attacks or to discuss what did or didn’t happen on other blogs/forums/websites.

    Hopefully the post itself, as well as the post (and discussion) on Mark’s blog will be useful to readers. (In case you missed it in the post, Mark linked to an article he recently wrote comparing performance of a collar strategy to performance of a buy & hold indexing strategy. You can find the post as well as my reply here: )

    In the future, I’d appreciate it if we could all do our best (myself included–I freely admit that I’m easily sidetracked) to keep discussions/comment threads on topic.


    PS: One comment was deleted at the request of its author. I now realize that for the sake of clarity I probably should have hit “edit” to remove the text rather than actually deleting it. Sorry ’bout that. 🙂

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