Volatility in equity markets, whether increasing or simply uncertain, is becoming a more prominent factor in the decision-making process for many advisers and their clients. Volatility is a source of unpredictable risk.
Among investors seeking to reduce volatility in their portfolios, many are employing options strategies to soften the potential drag on growth caused by market volatility. Other investors use options to seek incremental return from their concentrated (and often low-basis) positions. Advisers who master the range of options strategies can lower portfolio volatility and help reduce the severity of negative outcomes in bear markets while improving long-term compounded growth.
(See also: When buying puts to protect profits)
Managed options strategies can be designed for individual investors and institutional clients, and may be employed in separate accounts or mutual funds. These strategies are designed to alter the risk-return profile of existing investments with the goal of increasing income, boosting total return, reducing downside exposure or all of the above. These strategies seek to take advantage of the persistent difference observed between the implied and realized volatility of equity options.
Covered call options, index options and option overlay strategies can be designed in conjunction with existing diversified or concentrated portfolios to help investors reach their goals. These strategies can be implemented using listed options and involve no explicit leverage, credit exposure or counterparty risk.
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COVERED CALL STRATEGIES
A single stock call-writing strategy, for example, may offer a transparent, repeatable process for a managed covered-call-writing program that seeks to enhance total return and generate incremental income for investors with concentrated stock positions.
A call-writing program such as this uses out-of-the-money call options to maximize upfront premium and upside potential on the underlying stock. This strategy seeks to mitigate the number of shares sold and maintain as much upside participation as possible. Risk-and-return characteristics are monitored and evaluated on a real-time basis to identify profit capture and roll opportunities.
INDEX OPTIONS STRATEGIES FOR DIVERSIFIED PORTFOLIOS
For investors who already have a diversified portfolio, index option overlay strategies can be designed in conjunction with diversified equity portfolios or passive indexing strategies to help pursue enhanced total return, reduced portfolio volatility and to generate additional cash.
This strategy is implemented by selling call options on an index that is highly correlated to an investor's diversified portfolio. It seeks to increase total return (performance is generally negatively correlated to the underlying asset) without disrupting any existing portfolio allocations or existing active manager relationships, and allows investors to retain any manager-specific active exposure in their overall portfolio.
ABSOLUTE RETURN STRATEGIES
An options strategy that employs an absolute-return investment approach may be beneficial for some investors. This approach entails buying and selling equity index options in an effort to deliver consistent, positive returns that aren't correlated with most traditional asset classes. These types of absolute-return strategies look to take advantage of the general imbalance between implied and realized volatility by writing a series of call spreads and put spreads on the S&P 500 using existing investments as collateral (which can be any marginable security such as bonds, stocks, cash, etc.).
Using a transparent, systematic, rules-based approach, this strategy is designed to mitigate risk by establishing a maximum potential loss and utilizing multiple maturity dates. The maximum loss to a seller of exchange-traded, index option spreads is limited to the difference in strike prices, allowing a definitive potential loss calculation.
HEDGED EQUITY TO MANAGE VOLATILITY
Another way for clients with diversified equity portfolios to seek reduced volatility and mitigate the risks of extreme market movements is to invest in an option overlay that hedges the underlying equity exposure. A hedged equity strategy involves purchasing put options to protect the portfolio and selling call options to offset the initial cost of the put options on a selected stock index. The purchased put and the sold call reference the same index and have the same expiration date. The strike prices of the put options purchased are below the index level at the time of the purchase while the strike prices of the associated call options are above the index level at the time of the sale.
The portfolio is then managed with multiple tranches so the put protection and sold calls are constantly re-indexed to current market and volatility levels.
DEFENSIVE EQUITY STRATEGIES
A defensive equity strategy works to provide protection by “de-risking” the base portfolio and then selling fully covered index options to generate additional portfolio income. This strategy is designed to create implicit equity downside protection through an index core exposure of exchange-traded funds, and U.S. Treasury bills, which are then combined with selling options positions that seek to harvest a volatility risk premium.
Sophisticated advisers know that market volatility is persistent and cannot be ignored. Instead of seeing volatility as negative risk or liability to be combated, investors and their advisers should begin to think of volatility as an asset that can be managed and understood, and to exploit the insurance risk premium persistent in the pricing of options today.
Brad Berggren is a managing director of Parametric Risk Advisors, a registered investment adviser.