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How options can play a role in portfolios

It is important to analyze each strategy separately based upon their unique characteristics

Jul 12, 2017 @ 12:26 pm

By Micah Wakefield

In today's low yield, high-risk investment environment, traditional asset classes are unappealing. However, over the past several decades other "options" have arisen for investors. Option-based strategies have proven themselves through difficult market environments for equities, bonds and other liquid assets. These strategies seek to redefine the risk/reward trade-off through the usage of exchange-traded options. Investors literally have more options now.

Over the past decade, many different types of strategies that utilize options as a key component have become available. Morningstar now has a separate category for options-based funds. A 2015 study by Keith Black and Edward Szado found that funds utilizing options had risen from 10 in 2000 to 119 in 2014.

(More: 10 funds that sustained heavy losses in the first half)

The study also analyzed the performance of 80 options-based funds from 2000 through 2014, and found that the option-based strategies had similar returns as the S&P 500 but with lower volatility and lower maximum drawdowns. Moreover, many of the options-based strategies had higher risk-adjusted returns, as measured by the Sharpe Ratio, Sortino Ratio and Stutzer Index.

Although option-based strategies can be considered as an asset class, it is important to analyze each strategy separately based upon their own unique characteristics. Option-based strategies can provide benefits such as non-correlation, beta dampening, diversification and different return distributions and alpha generation. Historically, the use of options has often been categorically dismissed by some who label all options as too risky. Derivatives have often been incorrectly blamed for a lot of the mishaps of financial institutions, hedge funds and markets in general. In reality, excess leverage was normally the culprit. Perhaps it is natural to fear something that isn't properly understood.

Because of this, it is vital to educate investors on how options work and how they can play a key role in portfolios. Options are not a scary, esoteric, rarely used tool traded only by speculators and shadow prop desks. On the contrary, investors and institutions have used options for decades in many different ways to hedge risk and/or generate income.

(More: ESG investors like gains as much as anyone else)

OPTIONS DEFINED

In its simplest form, an option is an investable security that is usually exchange-traded, similar to stocks and bonds. It is a contract sold by one party (option writer) to another party (option buyer). The contract offers the option buyer the right, but not the obligation, to buy or sell a security or other asset at an agreed-upon price during a certain period of time or on a specific date (exercise date).

With the failure of Modern Portfolio Theory and traditional diversification to adequately protect portfolios during the tech crash in 2000-2002 and in the financial crisis in 2007-2009, many investors are now utilizing options as an investment strategy and as its own asset class. Since traditional diversification did not prevent major losses, strategies that directly hedge market risk are gaining more attention.

Option strategies have different objectives and results. Some option-based strategies, such as put-write, buy-write and covered call strategies act very similarly to traditional equity and can be down substantially during bear markets. Other strategies focus on direct risk mitigation and can provide unique benefits to a portfolio, especially through attractive up/down capture ratios, but these will normally trail during bull markets.

(More: Will new smart-beta strategies boost target-date funds' performance?)

Options are not for amateurs; they are best left traded by people with the expertise, knowledge, experience and technology to maximize their usage.

Option-based strategies can be accessed through mutual funds, hedge funds, separately managed accounts, and a handful of exchange-traded funds. Each vehicle and strategy has its own pros and cons and must be considered on an individual basis. But in today's uncertain market environment, all options should be on the table.

Micah Wakefield is director of research and product development at Swan Global Investments, a registered investment adviser.

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