Challenges with rolling up a collar strategy before expiration

[ChpBstrd]

I've long been a proponent of the collar strategy, where one buys shares, buys a put option, and sells a call option. This combination creates a possible returns profile where your potential losses hit a floor, and your portfolio can go no lower than that floor, but with a similar ceiling on how high it can go.

I advocate pairing this strategy with an Investment Policy Statement (IPS) which describes the conditions under which you'd be willing to sell your put for a profit and go un-hedged. E.g. "If QQQ drops 25% from its ATH, I will liquidate my long put options and go unhedged."

Retirements fail due to Sequence of Returns Risk (SORR), so if we can earn stock-market-like returns most of the time while avoiding maybe half of the damage from bear markets, then we can probably improve upon the odds of portfolio failure AND also hold a more aggressive portfolio than we would otherwise be comfortable with in pre-retirement or during the critical first years of early retirement.

Depending on the details of your collar, the time decay of your long put is offset by the time decay of your short call, so you are roughly theta-neutral. In terms of delta, you might end up with a portfolio of 100% stocks/options that is as volatile as a 60/40 or 50/50 stock/bond asset allocation. Both the long put and the short call move in opposite directions as your stock.

In terms of vega, you think this way: Volatility will spike if there is a stock correction, and that will increase the value of the put you want to sell into that correction. So buy your put at lower prices during low volatility for the extra boost you might obtain selling it in a time of high volatility. I simply use $VIX as a proxy for implied volatility. Buy puts when $VIX is low. Sell them when $VIX is high.

Between 6/6/2024 and 6/13/2024, for example, I entered a collar on QQQ at these prices:

300 shares QQQ @ $463.75 = $-139,125
+3 put options @ $10.83/share plus fees = $-3,251
-3 call options @ $10.51/share plus fees = $+3,150
---------------------------------------------------------
Net: $139,226 (~464.09/share).

My puts were at the 409.78 strike, so 11.6% below the price at the time.
My calls were at the 569.78 strike, so 22.9% above the price at the time.
Expirations for both were 6/20/2025 - about one year later.

So essentially this position could lose a maximum of 11.6% or gain a maximum of 22.9% over the course of a year. I really liked those odds and advocated them in the "most intriguing investment of the day" thread. First, another year of returns over 22.9% seemed unlikely, so giving up that upside was a cost I'd be willing to bear. Second, the maximum loss was manageable, and my puts could turn a major bear market into the experience of a minor correction. I set my IPS to sell the put if markets corrected 20% from their ATHs and planned to sit tight through next June.

Fast forward six months and my collar play looks like the image below.
QQQ has risen 14.26%, from 463.75 to 529.88.
My overall collar is up 11.63%, having captured most of those gains.
QQQ can rise another 7.53% before hitting my ceiling on returns.
QQQ can fall 22.7% from here before hitting my floor on returns.

The difference between my original maximum upside and my return plus the amount QQQ could rise to hit my maximum upside is explained by the time value left on my short call options. Those calls are now worth $15.63 per share, having risen 48.7% since I sold them. If stocks stay unchanged for another 6 months, that $15.63 liability will eventually fall to zero and contribute another 3.36% to my return.

Now though, I'm wishing I could consolidate some of these gains without waiting another six months. I'm growing concerned by the multi-month trend of rising inflation, by valuations, and by risks associated with tariffs.

My choices include:

1) Roll Up
Roll the put option up. E.g. sell my 409.78 strike puts expiring in June and buy the 479.78 strike puts. This move would limit downside to a little over 10% but it would cost about $7.21 per share, or $2,163. I'd have to move such funds into this account in order to not break up my 300 share block of QQQ.

2) Roll Up and Out
Close out both my put and my call positions, and roll them up to higher prices and out to December 19, 2025. For the put, I'd move to the 479.78 strike, allowing for ~9.5% downside. For the call, I'd choose the 609.78 strike, allowing for ~15% upside. This roll would cost $12.92 per share, or $-3,891 but it would reset my overall strategy another six months. As with #1 this would require additional cash.

3) Switch to Barbell
Exit the collar position. Buy 3 long-duration call options at the 529.78 strike, expiring in December 2025, for $55.47/share, and put the rest in 2-5 year bonds. The net cost would be $16,641 but that's all I would have to lose (10.7% of my current portfolio value would be at risk, though that risk is offset by receiving about 4-5% bond interest with the other 89% of my portfolio.). This would change my risk stance from limited upside and downside to only limited downside - which is out of alignment with my view that either modest gains or losses lie ahead. It would also shift me from theta-neutral to suffering theta losses every day. The major downside is that an at-the-money option only has a delta of about 0.5, so for each dollar QQQ rises or falls, the option only rises or falls 50 cents. I'd need to make a much larger wager, and expose even more money to theta, to achieve a delta nearer to 1. And if my potential downside is >20% I might as well stick with my current position.

4) Stop Loss Order
Set a stop loss order to sell my shares and buy back the calls if QQQ falls below a certain level. This order could be ratcheted up to incrementally lock in gains over time. The downsides of stop loss orders are well known. They're a great way to get shaken out of the market on a minor blip in an otherwise bullish environment. However, if the order was executed, I'd follow it up by purchasing call options to maintain exposure. The problem is IV would be high in such a scenario, so my call options would be purchased at exactly the wrong time. And then I have all the disadvantages of the Barbell.

5) Re-Allocate
Instead of a collar on 300 shares, maybe I should have a collar on 200 shares, plus some short-intermediate bonds. This is the most direct way to take risk off the table and does not

6) Add Negative Delta
My puts are cheap, so I could just buy more of them. I cannot sell more calls without going into margin, so that's off the table. Buying more puts would further reduce my portfolio's sensitivity to changes from now until they expire. This would come at a fixed cost to my upside - the cost of the puts. It's an elegant solution, but would require additional cash and would reduce the benefits of theta that I am enjoying now. 

7) Stay the Course
Accept that I now have >20% downside risk like everyone else, and accept that this is due to the market granting me the gift of 6 months of very high returns. Understand that theta is now working in my favor because my short call is depreciating a lot faster than my long put. A key benefit is that in June, I will probably watch my long and short options expire worthless and be able to establish a new collar with higher strike prices and further-out dates - exactly according to plan. Understand that even if there will be a 20% bear market and high implied volatility in early 2025, my long put options will appreciate by probably a few dollars each and my short calls would also benefit me. The volatility control function of the collar will work just as I planned it to, even if my options are out-of-the-money. As my short call gets closer to the money, its delta and theta increases, which helps offset the shrinking delta and vega of my long put.

Decision:
I'm going with 7) Stay the Course.

The sum of the deltas of my short calls and my long puts is about -0.44. So for every dollar change in QQQ, my options change the opposite way 44 cents. That's pretty good hedging, on par with the expected movements of a bond-heavy portfolio like a 60/40 or 50/50. As seen in the screenshot below, my options together moved in 45.4% of the opposite direction as my shares - very close to my delta calculation. And yet, over the past six months, I've captured 11.63% out of 14.26% of QQQ's gains.

In terms of delta per dollar (mid price / delta), my short calls are 42.96 per one unit of delta and my long puts are 53.13. Thus my short calls are a more cost-effective hedge right now than my far-OTM long puts.

Lessons Learned:
I still like collars! In the future, I might seek to stagger my collars so that my downside protection stays more consistent over time. However I'm also struck by how consistent my delta has stayed over time. My analysis has only found more reasons to love collars. Even when the market makes a strong run, there's still lots of downside protection.

[BicycleB]

Thanks for posting this! As someone still trying to learn enough about options to use them wisely, the illustration helps.