Mutual Fund Carries Built-In Protection

NEW YORK (TheStreet) -- Investors worried about a bond bubble but want a less-risky alternative to a stock fund may want to review Thomas Schwab's options-based Collar Fund(COLLX).

The mutual fund, which was started two years ago, has returned 2.3% over the past year.

Welcome to TheStreet's Fund Manager Five Spot, where America's top mutual fund managers give their best stock picks and views on the market in a five-question format.

What exactly is a collar strategy?

Schwab: It's a strategy where for each stock we buy, we also buy a put option for protection in case the stock goes down severely. In order to finance the put insurance, we sell a covered call option of about the same value as the put option. This is called a costless collar because the cost of the put is offset by the proceeds of the call.

How do you select the stocks in your fund?

Schwab: The key driver for our stock-selection process is to invest in stocks where the underlying call option premium is richer than the put option premium. For example, let's assume a stock that pays no dividends sells at $100 per share. The stock also has listed options where a one-year $90 strike put option trades at $6 per contract, and a one-year $110 strike call option trades at $8 per contract. Both the put and call are $10 out of the money, but the call is trading for $2 more that the put, which indicates that option investors as a group are bullish on the stock.

This is appealing to us for two reasons: First, the fact that option investors are bullish might be a positive indicator that the stock will rise, and second, even if there is no information in these option prices, if you collar the stock, you get an attractive reward-to-risk equation. If you buy the stock at $100, then buy the put for $6 and sell the call for $8, you have a net cost of $98. If that's the case, then the upside potential is $12 and downside risk is $8, for a reward-to-risk of 1.5 to 1.