Pandora Media (NYSE:P), which hit a 52-week high intraday, offers a good example of how optimal collars can lower the cost of hedging volatile stocks. Compare the costs of the two ways of hedging P below.
1) Hedging With Optimal Puts
Extremely high cost, but uncapped upside.
These are the optimal puts*, as of Monday's close, to hedge 1000 shares of Pandora Media (P) against a greater-than-20% drop between now and January 17th.
As you can see at the bottom of the screen capture below, the cost of this protection, as a percentage of position value, was extremely high, 19.98%.
2) Hedging With An Optimal Collar
Lower cost, 20% upside cap.
If you're willing to cap your potential upside at 20% between now and January 17th, this is the optimal collar to hedge 1000 shares of P against a greater-than-20% drop over the same time frame.
As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.73%.
If you want to pay even less to hedge, you can use a larger decline threshold, or a lower cap.
Possibly More Protection Than Promised
*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.
**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.