There is a lot of noise in the financial media everyday. Is the equity market over-valued or not? Is this the beginning of the end? Market volatility has increased considerably over the last two months starting around early February, compared to the placid days of 2017. This is also the time when clients may be getting calls from their investment banks about hedging equity exposure.
One of the investment myths that we sometimes hear about is the costless collar. It is a name associated with an equity hedging strategy where an investor who is long equity exposure would sell a call option and use the premium received to buy a put option, as a way to protect against losses in the underlying asset.
In an equity collar strategy, the buyer of the collar is giving away the right to any upside beyond a certain level (Sell Call) in return for protection against losses below a certain level (Buy Put). The combination of the two options is called an equity collar. These hedging strategies typically do not require any cash premium upfront and hence the term “costless” collar. On paper this sounds good, but in reality there is a significant cost associated with these strategies as they are a form of insurance that is purchased at an outrageous cost.
One of the key inputs to option pricing is the expected volatility. There are many models that investors use to estimate this volatility. In options market the expected volatility that is priced into a Call option is typically lower than a similar Put option. This concept is called ‘Volatility Skew’. For example, a 95% Put (protection at 5% below current price) will likely have a higher volatility expectation and a correspondingly higher premium/cost than a 105% Call (upside above 5% of current price). So in the real world you cannot hedge a long equity position by selling a 105% Call and buying a 95% Put at zero initial cost. If you need loss protection beyond the initial 5% (Buy 95% Put) then we may have to sell a Call at 103% or lower. So we would pay away a lot more upside for getting the protection we would need. If one were to do this on an ongoing basis we are likely to pay away any equity risk premium and the resulting outcome would be very similar to simply de-risking or selling the equity position. So an equity collar could be ‘cashless’ but is far from ‘costless’.
A better way to think about hedging is to benefit from volatility skew and buy protection at a lower cost. There is always a cost to buying insurance. Just don’t pay more than you have to.
Photo Credit by Lukas Budimaier on Unsplash