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Collar Proves a Cool Tool for Hot Stocks

NEW YORK ( TheStreet) -- In January 2010, I wrote about a relatively new and innovative mutual fund called the Collar Fund (COLLX) which is managed by Summit Portfolio Advisors.

The basic strategy of the Collar Fund is to buy stocks with a combination of attractive fundamentals and attractive options premiums. Simultaneous to buying a stock the fund will sell a call option approximately 10% out of the money and use the proceeds to buy a put option that is approximately 10% out of the money.

The options trades are done such that the call premium always exceeds the cost of the put. Part of the strategy relies on the fund pocketing the difference for fund holders and the managers take it as a positive sign that the market values calls more than puts.

The other strategic dynamic is the reward-to-risk ratio for each holding, which ideally would be 1.5 to 1 but will not be less than 1.0 to 1. The example I used in the first article to illustrate reward to risk was that the fund buys a stock for $100, sells a call option struck at $110 for $8 and buys a put struck $90 for $6 which creates a cost basis for the stock of $98 ($100 price minus $8 call premium plus $6 put premium). The maximum loss would be $8 per share ($98 down to $90) and the maximum gain would be $12 ($98 up to $110). The potential $12 gain versus the potential $8 loss creates the 1.5 to 1 reward to risk ratio the fund seeks.

The stocks held in the fund are usually quite volatile. At the time of the previous article the top holdings included Rambus (RMBS) and Potash Corp of Saskatchewan (POT). As of June 30, the top holdings included Apple (AAPL) and F5 Networks (FFIV). Despite the holdings being very volatile the fund is actually marketed as a proxy for a bond fund. The option collars greatly reduce the volatility of the fund and the fund literature compares its performance to the iShares Barclays Aggregate Bond Fund (AGG).

Since inception the Collar Fund is up 7.1% vs. a return of 14%, including dividends for AGG. For the trailing 12 months the Collar Fund lags by slightly less than 1%. While that might not seem so great it is important to understand that the Collar Fund does not expose investors to interest rate risk the way a bond fund like AGG does. The Collar Fund has not paid a meaningful dividend so it may not be a real substitute for an entire bond portfolio but it has utility as a tool to reduce the overall interest-rate risk of a bond portfolio (on a price basis, with no large increase in interest rates, the two funds have traded very similarly).

The other role this fund can play is for investors who allocate a portion of their portfolios to absolute return funds. Since inception the Collar Fund has traded right in line with both the Merger Fund (MERFX) and the Index IQ Hedge Multi Strategy Tracker ETF (QAI) , two popular alternative funds. A small slice of a diversified portfolio allocated to funds like these offers a good chance of smoothing out the ride over the course of an entire stock market cycle.

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At the time of publication, Nusbaum was long MERFX, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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