The Reverse Dispersion Equity Collar

This is an advanced level topic (i.e. it may put you to sleep)

The reverse dispersion equity collar is a strategy to reduce the cost of portfolio insurance through two main mechanisms: 1) Implementing an equity collar and 2) Putting option pricing theory to work in our favour through reverse dispersion.

The Equity Collar

First, let’s have a backgrounder on the equity collar. If someone wants to protect their portfolio from loss without selling out the portfolio (for example the investor has a large unrealized capital gain and only expects short-term market volatility), they can purchase put options. The put options gain in value if the portfolio falls and the gain on the puts offsets the loss on the portfolio.

However, purchasing a put option contract costs money. To reduce that cost to the investor, they can in turn SELL call options. This gives someone ELSE the option of buying away the portfolio if it hits the strike price. The investor will receive money for selling these call option contracts which can offset in part, or in whole, the cost of the portfolio insurance (the put options). What this does is serves to limit the downside AND upside of the portfolio’s performance for the length of the options – this is known as the equity collar.

For a more detailed explanation, you may visit the guest article I wrote for the Million Dollar Journey that focuses strictly on the basic Equity Collar.

The Reverse Dispersion Strategy

In a nutshell, option pricing is heavily influenced by volatility of the underlying security. Generally speaking, the more volatile the underlying security (or portfolio) the higher the price of the option since more volatility means more chance of the underlying asset hitting the strike price.

There are other variables that affect option pricing as well: 1) Time – the longer the option contract the more chance the underlying asset has to hit the strike price. 2) Distance to Strike Price – the closer to the strike price the underlying asset is, the more it tends to be worth (again, since it is more likely to become “in” the money).

So here is the reverse dispersion strategy in motion using a basic example:

1. You buy put options on the entire portfolio for 1 year, that are perhaps 10% out of the money
2. You sell call options on the separate stocks that make up the portfolio for 1 month, that are perhaps 5% out of the money, and keep rolling them over every month for the year

A more concrete, although more cumbersome, example would be owning the TSX/60, buying 1 year put options that are 10% out of the money on the index and selling monthly, 5% out of the money call options on each of the underlying 60 stocks, every month.

Less Volatility on the Portfolio = Lower cost on the puts

The volatility of the TSX/60 as a portfolio of stocks would be less than the volatility of any one constituent stock since at any time some of the 60 stocks are going up, and some are going down and some are not changing much. Since all the 60 stocks are not perfectly positively correlated, the volatility of the portfolio is decreased. Since volatility is decreased, the put option on the entire portfolio as a whole costs less than buying put options on each individual portfolio constituent separately.

On the other hand, we are selling call options on each of the individual 60 constituents of the index, instead of selling call options on the entire index. Each of the constituent stocks separately are more volatile than the portfolio as a whole, hence the options are worth more and hence they are going to generate more income to offset the cost of the puts.

Taken together, we have bought 1 set of put option contracts for 1 year which is 10% out of the money versus selling 720 sets of call option contracts (60 per month, for 12 months) which are each 5% out of the money. The odds of a stock hitting the 5% out of the money strike price in one month are low, maybe around 15%. That means you will have some additional turnover in the portfolio and you will need to replace some stocks every month, and write new calls. However, by using a lower strike price distance you increase the income received from the call options. If you pick your spots, you can earn more income from the calls than you spend on the puts, implementing a net-credit collar.

What would be a situation for considering this?

Let’s say you are a large, active investor on the fence about energy in Canada. You see that it’s been on a tear, but so many people are convinced it is a supercycle. You have a large unrealized gain, and want to protect against a near term correction, which could be severe, and still participate in any continued upswing. This might be appealing as you could in essence get free portfolio insurance (with a 10% deductible – which is another way of saying the puts are 10% out of the money). Further, a portfolio manager who runs this strategy often tells me that the time and distance-to-strike differentials of the reverse dispersion allows for only writing calls on half the positions to offset the cost of the put contract – which means only half of the portfolio may be capped on the upside in case there was an across the board surprise bull run.

Please do not attempt to engage in a reverse dispersion equity collar without first consulting with a qualified financial advisor. This is a complex strategy, normally reserved for large portfolios or institutional money management. (Imagine having to enter 720 call option orders!)

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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