NEW YORK (TheStreet) -- The curiously named Collar Fund (COLLX), which was started last June, follows a unique strategy among stock mutual funds. And its volatility resembles that of a bond exchange traded fund.

"Collar" may ring a bell, as it's named for an options strategy. A collar consists of buying a stock, selling a call option and using the proceeds from the call sale to buy a put option. The Collar Fund targets call options at about 10% out of the money and put options at about 10% out of the money, dramatically reducing volatility. The fund is managed by Summit Portfolio Advisors, a firm that has followed such a strategy for separate accounts for several years. The fund ought to have a high correlation to the stock market but with a fraction of the volatility.

I had a chance to talk with lead manager Tom Schwab. He gave the following example to illustrate what the company does. It owns proprietary software that screens for attractive options pricing among mostly large-cap stocks. If the screen finds a stock trading for $100 a share, managers will look at the options pricing. They would be inclined to sell a call option struck at $110 and buy a put option struck at $90.

A call option priced higher than the put option would be attractive. There are two reasons for this. If managers can sell a call for $8, to use Schwab's example, and buy the put for $6, the fund pockets the $2 difference. In addition, such a move would be viewed as a positive-sentiment indicator because the market would be willing to pay more for an upside move than downside protection.

Continuing with the example, the downside of this position is $8 per share (the net cost would be $98 per share and the put caps the loss at $90 per share) and the upside is $12 per share (the collar allows for capturing gains up to $110 per share). That creates a ratio of reward-to-risk of 1.5 to 1. The managers would hope to have a 1.5-to-1 ratio, or better, for each position, but they wouldn't go below a 1-to-1 ratio.

The fund has 73 holdings, and most of the collars on those stocks are due to expire next January. The way the Collar Fund is managed, it's unlikely the current positions will change unless new money comes in. The significance here is that the managers won't unwind positions early. So for each position, volatility is limited to the range between the strike price of the call option and the strike price of the put option.

Many of the stocks are volatile, so the chance that option premiums are rich and themselves prone to volatility is easy to imagine. The largest stock is Rambus ( RMBS), followed by InterOil Corp. ( IOC), Potash Corp. of Saskatchewan ( POT), Research in Motion ( RIMM) and Apple ( AAPL).

Since the fund's inception a little more than six months ago, it has risen 5%, while the S&P 500 Index has jumped more than 20%. The results show that the fund is a proxy for an alternative strategy or an absolute-return strategy. Schwab likened the fund's volatility to the iShares Barclays Aggregate Bond Fund ( AGG).

I asked Adam Warner from the Daily Options Report to weigh in on the fund and the strategy. He noted that, indeed, "collars are a nice low-risk, low-reward strategy." Warner said a risk for fund holders was the large weighting to the materials sector, at 20% of assets versus 3.5% for the S&P 500. In my opinion, that allocation is more likely to cause a drag in a flat market where materials fall less than the roughly 10% price point of the put.

There are a couple other risks as I see it, one intermediate term and another longer term. The fund is tiny. It has about $14 million in assets, which is microscopic, but has been getting about $2 million a month in new assets. If the fund is to be successful, it will have to manage growth in assets, which isn't easy to do. The longer-term risk is that, as the managers screen for stocks with suitable options pricing, the pricing dynamic they seek may have an urgency that might require buying now and researching later. That's unlikely to hurt the fund as the put options give protection. Still, the fund could lag behind its objective.

If the managers can successfully navigate these issues, the fund could play a vital role as a bond substitute that dampens volatility, but not an income source, if interest rates go up as some fear is likely.

At the time of publication, Roger Nusbaum had no positions in the securities mentioned.

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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