Quality Sentiment Dynamic Collar Strategy

Click here to view the current positions and the latest transactions (only for subscribers)

Introduction to the investment strategy

If you are a conservative investor that appreciate downside protection while retaining upside potential, this strategy is for you. In this strategy you invest in 'high-quality' stocks with solid sentiment, all within 'high-quality' industries. Downside protection, insurance, is added to all stocks by means of long-dated put option purchasing. The insurance is financed by selling short-dated call options above the market. The call options are rolled dynamically as the prices of the stocks change and time passes.

One position consists of a combination of three legs: (i) a long stock position, (ii) a long long-dated put option and (iii) a short short-dated call option. This combined position is in the options world called a 'Collar', hence the name of the strategy. The chart to the right shows the profit/loss graph for the options collar strategy.

One interesting feature worth mentioning is that of positive time-value (or time decay). Every individual collar, aggregated to the overall portfolio, has positive time-value, i.e. all else being equal, as one day passes the value of the portfolio increases. With option terminology, the strategy has positive Theta.

80% - 90% of all positions are ultimately closed with a profit. The probability of experiencing a negative return over a full year is extremely low with this strategy.

Portfolio composition - how are the positions determined?

The investment portfolio consists in this strategy of long stock positions with downside protection. The stocks selected for inclusion in the portfolio are determined in the following way:

• The top 30 quality industries are established. This is done by aggregating the individual stock scores in all of the industries that our investment universe is divided into. This step is taken in order to achieve a good level of diversification. We do not want to concentrate the stock positions to merely a few industries.

• From the top industries, the stocks selected are those with an FF Quality Score above 60% that simultaneously has an FF Sentiment Rank of at least #2, i.e. they are at least ranked as a 'Buy' along the sentiment dimension.

• There are also a few criteria related to the options: (i) there should be an active options market for a particular stock, (ii) the call options should trade at an implied volatility of 30% or more, (iii) there should be long-dated (LEAPS) put options available, (iv) the bid-ask spreads should be tight, (v) the implied volatility of the put options should not exceed that of the call options.

• The portfolio consists of 15 - 25 stocks over time.

Protection

At the same time as the stock investment is made, protection (or insurance) is established through the purchase of a long-dated at-the-money put option. An option with a long time left to expiration is selected in order to minimize the negative effect of time erosion of a long/owned option. An owned option decreases in value as time passes.

Financing of protection

The protection is financed by dynamically selling short-dated call options above the market. By using short-dated options, that are sold, the time value gain is maximized. The call options are rolled dynamically up, down and out as time progresses and the price of the stock changes.

Entry/exit - when are the positions changed?

New entries to the portfolio are determined after the weekly update of the FF Stock Rank.

An exit of a combined collar position is made in the following cases:

• After a price increase in the stock, when the short call cannot be rolled up and out for a credit. This is a case of profit taking.
• When a trailing stop is triggered. Also a case of profit taking.
• After a period of price volatility, when the short call cannot be rolled up and out for a credit. This could be either a profit or a loss realization.

The short call is rolled up and out when the stock trades above the strike price of the option. It is rolled for a credit. If the stock trades lower, the short call is rolled down and possibly in.

The long put option is rolled out when the time-value erosion starts to become severe. This typically occurs 30 - 40 weeks before expiration. The put option is rolled down when the stock trades significantly lower.

Exposure

The exposure of the long stock positions ranges between 100% and 150%. The option positions also has a net long cash exposure. The resulting total exposure is lower than 200%. This means that margin trading is in effect in this strategy.

Risk Management

The risk of loss is handled by means of outright purchase of insurance; when the price of a stock declines the value of the put option increases. There is also industry diversification - the stocks in the portfolio are selected from 30 industries.

Results - what to expect?

This is a conservative strategy with an expected long-term return of 9% - 14% per year, a significantly lower annual standard deviation and a Sharpe Ratio of 1.1 - 1.5.

Risk - which types of market environments are detrimental to the strategy?

The strategy experiences hardship in periods of high volatility, e.g. if the short call is rolled down after a price decline of the stock and the price thereafter quickly reverses and the call needs to be rolled up and out. In these situations a loss could be locked-in and the position closed at a loss.

Also, a situation of a general market down-turn is to some extent negative to the strategy as the portfolio is net long and the correlation with the general market can be expected to be positive on the up-side as well as on the down-side.

Model portfolio size

The position sizing is based on a model portfolio of US$150,000. If you are running a larger/smaller portfolio you need to adjust the position sizes in relation to the model portfolio. Depending on the portfolio size, there could be situations when some stocks are traded in odd-lots.

Updates

You will by e-mail receive the transactions that are to be executed as a consequence of the latest portfolio update. Current positions are found here on the web site.

Sign up

To gain access to the current positions and coming portfolio updates, please sign up here.