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Collar that Dog...

Written by Dane Czaplicki | Nov 06, 2023

 

There is something romantic/primal/freeing about walking with my dog off-lead. Until you meet my dog. London, our German Shorthair Pointer, is true to his breed. He is a beast of an athlete and has a nose for smells which is basically indescribable. You have to see this dog in action. He doesn’t ever walk. He runs. He doesn’t sit still. He meanders to and fro constantly. I would not say hyper, however, just a fully charged engine meant to move, not to sit idle. You could train him to just walk at your heal, but that to me would be like training a bird not to fly. It is unnatural. Each time we go to the woods, my decision becomes, let him run free, or keep him on his leash and collar as if we were walking in the neighborhood. Each time is different and varies on the circumstances. Have the afternoon, with no time constraints, few people around – say goodbye to the leash, about to leave on vacation, lots of deer around, and have to be on the road after a short hike, perhaps you enjoy the short jaunt tethered.

As I walked him this morning, I was pondering my decision process for collaring my dog and how much it was like the decision process for whether to collar an investment portfolio.

In the world of finance, a collar is a risk management strategy that involves using options to limit the potential losses and gains of an underlying asset. It is often used by investors to protect their portfolios from significant downside risk while still allowing for some upside potential.

The main components of a collar are a long position in an asset, the purchase of a put option, and the sale of a call option. The put option serves as a form of insurance, providing the investor with the right to sell the asset at a predetermined price, thus limiting potential losses. On the other hand, the call option sets a cap on the potential profit that can be earned from the asset.

In the image below, the blue stocks line represents an uncollared portfolio where the portfolio has unlimited upside and unlimited downside. The green line represents the same portfolio of stocks, augmented by the application of a collar (sale of call option + the purchase of a put option). The collar alters your stock portfolio potential trajectory: Capping gains, and limiting losses.

One of the key advantages of implementing a collar strategy is the ability to protect a portfolio from market downturns without completely exiting the market. This can be particularly beneficial for investors who have :

  1. Specific short-term cash flow needs from an otherwise long-term portfolio,
  2. A portfolio of stocks they want to sell but want to deal with the tax event until the new year, or
  3. A near-term concern about the market but don’t want to disrupt their long-term plan.

However, there are also some drawbacks to consider. Collars can limit the potential for significant gains, as the call option sets a ceiling on the profits that can be realized from the asset. Moreover, the use of complex options strategies may require a certain level of expertise, and not all investors may be comfortable with the intricacies of these financial instruments.

Expanding on the analogy of collaring a portfolio and of walking a dog, applying a collar to a portfolio is akin to adding safety and protection to one's investments while still allowing for some flexibility and movement. Just as a dog on a collar may not have the same degree of freedom as one without, an investor employing a collar strategy may not experience the same level of potential gains as one who is fully exposed to market fluctuations.

The romantic/primal/freeing part of being on the hike or walk in the woods is still there, dog on leash or running free. I believe that staying invested is almost always the long-term right decision and market timing is a fools game, but options are a powerful tool for risk augmentation to the portfolio. So always hike and stay invested, just consider the tools available to you to risk-adjust the experience when the need arises.

In conclusion, while collaring portfolios can be a valuable risk management tool, it is important for investors to carefully consider their individual financial goals and risk tolerance before implementing this strategy. Seeking guidance from a financial advisor or conducting thorough research can help investors make informed decisions regarding the use of collars within their investment portfolios.

 

About the Author – Dane Czaplicki, CFA®

Dane Czaplicki is CEO of Members’ Wealth, a boutique wealth management firm that offers a comprehensive approach to serving individuals, families, business owners, and institutions. The firm’s goal is to preserve and grow its clients’ wealth to endure over time, while thoughtfully evolving its strategy to suit an ever-changing world. With over 20 years of wealth management experience, Dane and the Members' Wealth team thrive on bringing clarity and confidence to clients' unique situations. He believes everyone needs sound financial advice from someone whose interests are aligned with theirs, and is determined to put service before all else.

Dane received his MBA from The Wharton School of Business at the University of Pennsylvania and his bachelor’s degree from Bloomsburg University. Outside work, he enjoys spending time with his wife and kids, hiking and camping, reading, running, and playing with his dog. To learn more about Dane, connect with him on LinkedIn.

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