Balance Risk and Reward with a Collar Overlay Strategy

Introduction

What if you could protect your portfolio from sharp declines and still earn extra income—without constantly rebalancing or shifting your long-term investment plan? In a world where volatility can erode returns just as quickly as opportunity creates them, many investors seek strategies that provide both upside participation and downside protection. The collar overlay strategy delivers exactly that.

At WealthEngine.AI, we apply a systematic collar overlay—buying protective SPY puts while simultaneously selling SPY calls—on our core factor portfolios: Momentum, Value, and Smallcap. This approach creates a defined range of expected returns each month, combining income generation with capital protection. It’s a powerful hedge-income hybrid, especially suited for conservative investors seeking greater predictability without abandoning equity exposure.

What Is a Collar Strategy?

A collar overlay is a combination of two option positions placed over a stock (or portfolio):

• •Buy a put to cap downside losses (protection)
  
• •Sell a call to generate income, which partially or fully pays for the put (trade-off: capped upside)
  

This structure forms a "collar" around your portfolio returns: limiting downside below the put strike and upside beyond the call strike. At WealthEngine.AI, we implement this strategy using SPY index options—rather than individual stock options—for liquidity, simplicity, and broad market risk coverage.

How the WealthEngine.AI Collar Overlay Works

Here’s how our monthly collar overlay is systematically applied:

• •Hold Core Portfolio: Momentum, Value, or Smallcap strategy remains unchanged
  
• •Buy SPY Put Option: ~0.2 delta strike, 1-month expiry for downside hedge
  
• •Sell SPY Call Option: ~0.3 delta strike, same expiry to collect premium
  
• •Maintain Until Expiry: Unless extreme market movement warrants early action
  
• •Repeat Monthly: A new collar is constructed each month
  

The structure ensures that protection is always in place, and income generation remains consistent. This rolling mechanism aligns with WealthEngine.AI’s philosophy of disciplined, data-driven overlays.

Why SPY Options?

Using SPY index options—rather than options on each individual stock—offers significant advantages:

• •Cost Efficiency: Lower commissions, fewer transactions
  
• •Liquidity: SPY options are among the most traded in the world
  
• •Systematic Risk Coverage: SPY reflects overall market risk, the key driver of drawdowns
  
• •Simplicity: One collar per month—easy to implement and track
  

This streamlined approach allows us to enhance return predictability while maintaining our conviction in stock selection and factor exposures.

Modeling & Backtesting Approach

To validate the effectiveness of this strategy, we conducted a backtest using the following parameters:

• •Call strike: Monthly SPY ~0.3 delta
  
• •Put strike: Monthly SPY ~0.2 delta
  
• •Timing: Trades entered at start of each month, closed before expiry
  
• •Pricing model: Cox-Ross-Rubinstein framework, incorporating the VIX index as a proxy for implied volatility and the U.S. 3-month Treasury yield as the risk-free rate"
  

This framework ensures real-world consistency in cost estimation, payoff structure, and market responsiveness.

Backtest Across WealthEngine.AI Portfolios

We tested the collar overlay across three flagship portfolios—Momentum, Value, and Smallcap. The results showed a significant reduction in drawdowns and steadier returns across volatile regimes.

Value Portfolio + SPY Collar Overlay

Momentum Portfolio + SPY Collar Overlay

Smallcap Portfolio + SPY Collar Overlay

While the collar strategy does modestly limit upside in strong bull markets (due to the short call cap), it shines in sideways or turbulent markets—delivering smoother equity curves and better risk-adjusted returns.

Conclusion

The collar overlay strategy offers an elegant blend of protection and income—essentially allowing investors to trade some potential upside for peace of mind. At WealthEngine.AI, we deploy this overlay across our core factor portfolios using SPY index options, ensuring the approach is cost-effective, systematic, and scalable.

Key Takeaways:

• •Defined risk-return profile each month
  
• •Enhances resilience in turbulent markets
  
• •Aligns with long-term investment discipline
  

For investors who want to stay invested without being overly exposed, the collar overlay offers a smart compromise—adding a layer of control without diluting your core investment strategy.