Options strategies advisers can put to work now: Webcast transcript

How to manage clients' risk, generate income, defer taxes and reduce volatility

Sep 12, 2010 @ 12:01 am

The following is an edited transcript of the webcast “Options strategies advisers can use now,” held July 20 in New York. It was moderated by deputy editor Evan Cooper and senior editor Dan Jamieson.

InvestmentNews: Dennis, you are in Microsoft-land in Redmond, Wash. How do you help manage risk for your clients, many of whom, I am sure, are Microsoft executives and employees?

Mr. Gibb: We are sitting right in the middle of Microsoft Corp. In fact, most of the time when you see any of their executives on CNBC, that studio is about a three-wood shot from my office. So we have Microsoft people all over the place. And I have been in the area for about 21 years. So I went through all of the glory years of Microsoft from 1989 on.

We have a lot of clients who are executives and have been there 10, 12 years. They have built up a lot of stock from options exercises, and now from grants and from their purchase program. One of the things that you find out is, when you concentrate in one stock in a portfolio, no matter what you do, you can't overcome that volatility that is introduced by that stock. So what you have to do is find ways to reduce that volatility.

Up until 2000, the big problem with Microsoft was that the stock kept going up every year. And a lot of people were taking margin loans, so options were used as a way to help pay down the margin loan to protect against sudden drops in the stock that might lead to a margin call.

Since 2000, it has been exactly the opposite. The goal has been to increase the returns off the asset, to dampen down the volatility and to protect against decline in value. So we have changed strategies twice with Microsoft, and now we are spending a lot of time working on doing collars, writing calls and doing spreads on it, trying to time sales and to protect against losses on future exercises.

InvestmentNews: We are going to get to the “how to” for that with Joe a little later. But before we get to Ken, Dennis, tell us a bit about your firm.

Mr. Gibb: I started in business in 1973. I founded Sweetwater in 1989. We manage about $1.1 billion. A good portion of that is for Native American tribes across the country. Then we have a group of high-net-worth individuals, all taxpayers. We manage not only Microsoft executives but other people who have made money through venture capital, or through selling their businesses, or have just accumulated money over time.

And we get a lot of people coming in here looking for an independent source of ideas and evaluation of what they are doing.

InvestmentNews: Ken, what do you do in the options area in the way of income and tax help?

Mr. Winans: I set up Winans International back in 1992. I originally entered the business in the early "80s, primarily on the research side. Whether it was luck or skill, the timing of the launch of Winans International in 1992 as a registered investment adviser was very good for anybody who wanted to get into the stock market. We are now up to about $150 million in assets.

InvestmentNews: Joe, tell us about the Options Industry Council and some of the issues facing advisers that you see in your travels around the country.

Mr. Burgoyne: Our entire mandate is options education, whether it is for the financial adviser, the institutional house or the retail investor. Hit the street, get people to put their toe in the water and get comfortable with options. We find that actually doing it is the biggest obstacle when it comes to financial advisers. Once they finally put that toe in the water, things start to work for both their practices and their clients. So we are out on the street 24-7, spreading the gospel of how options can help the financial adviser's portfolio.

InvestmentNews: Ken, what do you do for your clients?

Mr. Winans: You have to understand our firm's philosophy in managing money. I am a chartered market technician by designation. When it comes to asset allocation, we do a lot of top-down technical work on how we are going to deploy money in the investment markets. And when I say “investment philosophy,” understand that even with all the headlines saying how different today is, I believe I can go back over the last 100 years and find variables very much in play today that were in play back then. Ultimately, I don't think investor emotions change at all. We would like to think that we have gotten smarter and more technological, but the reality is that we seem to make the same errors.

I believe that from market views and long trends, and price lead fundamentals and economic data, you can find textual indicators, not only for equities themselves, but certainly with options. We have ended up getting a lot of new business this year, and it is primarily because we offer an offense and a defense. People are tired of hearing about “buy and hold,” they want to know when you are going to get out if things go wrong. So as people hear me talk today, you have to understand I am looking at it from that perspective.

I'm actually defensive right now. A couple of our key indicators have rolled negative, and we have been raising cash; we have been taking things to a level where clients are comfortable. Clearly, the strategies that worked well in the "80s and the "90s did not work well these past 10 years. When you talk about options and other types of defensive strategies, or when you are trying to convince a client to get back into the market after a 21/2-year bludgeoning, we actually found options were an effective tool to get people to re-engage the equity market because you take less risk to do it than saying, “Let's go back and rebuild your portfolio now” — they look at you like you are crazy. “Are you kidding? I've been losing money for 21/2 years.” So my point is simply this: If we continue to have this kind of a market — and I will talk a bit in a moment about options — options strategies work well. If you are looking at no general upside momentum and no relief in sight, anybody out there using buy-and-hold knows it is going to be a very, very tough sell.

InvestmentNews: So what would it take for you to switch from being defensive to being offensive?

Mr. Winans: We use several key indicators. The No. 1 thing is my trend indicator, which, to make it simple, is a variation of the 200-day moving average. When I have a break in the 200-day moving average, we are officially offensive. It means that we are not hesitant to raise cash.

InvestmentNews: Dennis, going back to your work with executives, do you use options to help them generate income?

Mr. Gibb: We do. We like to generate income for people. And options give us a way to add a little extra to the portfolio. By using options, you can add 1, 2, 3, maybe 4 percentage points a year to your return. Now that doesn't sound like much, but if you are looking at an overall return per year of 6% to 8%, adding 4 percentage points of return makes you a hero.

For the executives, however, we are not interested as much in generating income as we are in protecting the portfolio. That's because executives, depending on their position, sometimes can't sell when they want to because they are restricted by earnings periods or blackouts or whatever. So what they want to do is protect themselves. Sometimes it is only for a month. Sometimes it is for a couple of months. They just want to protect the situation.

InvestmentNews: There is a question from the audience: “Is there anyone out there educating the insurance carriers who offer [errors-and-omissions] coverage that options aren't bad?

Mr. Gibb: We have one custodian, who I am not going to name, who will rarely approve any client for anything other than covered calls. We have another custodian who looks at the same data and approves them for the highest level they can. Now, the only time you are really risky is when, for example, you short a stock by buying a put and it keeps going up; theoretically, you have unlimited loss. But most of the time you are doing the spread, your loss is limited to the expiration of the call. Mathematically, you can figure it out. And one of the beauties of the options market right now is that it is mathematically determined. There are thousands of computers out there, searching every day for possible combinations. And you can tell almost within a penny where that option is going to trade, given certain conditions in the market.

InvestmentNews: What is the biggest loss a client of yours has suffered as a result of options trading — just from the option itself?

Mr. Gibb: I had a client who was doing a strategy where, using volatility, they would sell calls and sell puts on the S&P 500. In October 2008, they lost something in the area of 24% of their portfolio.

Mr. Burgoyne: I want to get back to the perception that options are risky. What Ken just described couldn't be more risky. Sell-call, sell-put, no protection — it is all about managing the portfolio. If you do a spread, if you sell a call spread and sell the put spread rather than just sell that strangle or straddle that he is describing, you have a manageable option position. It gets down to understanding risk in a portfolio. Nothing is more important, and it does not have to be complicated.

Mr. Gibb: I agree with that. What this guy was doing was extremely risky, and is not for everybody.

InvestmentNews: And how did the compliance people let that happen?

Mr. Gibb: He was using a very large custodian who really didn't care because he had collateral there — good collateral. When you start using options with a client, you first have to decide what it is you are trying to do for the client. Are you trying to generate income? That is one set of strategies that will fall under income generation. If you are trying to hedge risk, that is another set of strategies. If you are trying to collar or protect a position from declining value, that is another series of issues. You can get very sophisticated with this stuff and you really don't have to.

Mr. Winans: One thing that Dennis just said: Knowledge is the key and how you explain it to clients is critically important. When you try to get option approval for a client at any of the major broker-dealers, the clients are all going to get the scary information that they can lose all of their money, that they are going to be destitute, and we have all seen it. They have to do what they have to do.

But when we talk about loss, how much of one's portfolio is actually in options? I don't think anybody on this call is promoting that 100% of somebody's portfolio be in options. When I was laying out the strategy we were using, you are talking about 10% of a portfolio. So what is loss relative to a portfolio? But I mean you can find people who have blown themselves up on pretty much any kind of investment vehicle out there, including bonds. We all know that.

InvestmentNews: Including even cash mutual funds?

Mr. Winans: Absolutely. But the issue of E&O just came up for us, especially with our mutual fund company. We had to go through a big rigmarole on E&O insurance because we were using derivatives.

InvestmentNews: Let's switch gears for a second and talk about taxes in two ways. What tax consequences will investors face from using some of these options strategies?

Mr. Winans: The problem is that we don't know what's coming up, taxwise. Ask us in 2011.

Mr. Gibb: I'll handle a little bit of it. We don't know if income tax rates are going up. We don't know if capital gains rates are going up. We really don't know. So that makes it kind of a guess at this point.

But in general, here is what happens now. If you write a call, the options premium that comes in is generally treated as ordinary income — which is helpful in some ways because you can use it to off-hedge short-term gains and that sort of thing. There used to be techniques that allowed you to move taxes forward using options. The Internal Revenue Service finally figured that out and did away with it.

If you are doing an options strategy, most of the time you have to make the case to your client that you are going to increase their income. That is the answer. Now I have very rarely had a client tell me they don't want any more income.

InvestmentNews: So in this case, paying the taxes is the least of their problems. As long as they are getting income, it is OK.

Mr. Gibb: It is not a problem. I have never had a client tell me “no more income.” I have had clients tell me “no more capital gains” because of the effect it will have on the alternative-minimum-tax preferential item. But I rarely have a client tell me not to produce any more income.

InvestmentNews: What about doing it within an individual retirement account? Is that possible? How does that work?

Mr. Gibb: If you can get ap-proved. One of the toughest areas in which to get options approved is to do them within retirement plans.

InvestmentNews: Even if it is a conservative strategy?

Mr. Gibb: It doesn't make any difference. The firms are really hesitant about using retirement plans for anything that might have the word risk associated with it, even though not doing it increases the risk in the portfolio. Because options are classified as a risky product, many firms will just not allow it to happen. It is a great income multiplier if you can get it in the retirement account. But you have to also remember there are some options strategies that are absolutely forbidden for retirement accounts.

InvestmentNews: Ken, anything to add?

Mr. Winans: The only thing I always tell our clients is that we are not tax experts. You should have your accountants look things over. And I have had times when an accountant who doesn't understand options has pooh-poohed it and the client has said no, and I have to just obey what they have said. You have to pick your battles and if somebody is not 100% onboard with this, you need to be very careful. We have all had dealings with clients who suddenly got amnesia and didn't remember that we talked about risk, didn't understand it. You don't want to go down that path in a volatile market — it's not worth it.

InvestmentNews: Can we talk about some specific options techniques?

Mr. Winans: I would like to talk about covered calls. A lot of times people talk about that as a no-brainer way to make money. But here is one thing to think about: If you decide to talk to clients about this strategy, and then three months later, or let's say a month later, they plan to sell the stock, it is going to leave you with a naked situation. I am going to suggest that before you go out and promote that strategy, it might be better for you to find out what time frame the client is comfortable with about hanging on to that stock. You can get yourself in a very funny pickle, especially in volatile markets, if you have clients trying to adjust the underlying securities. So just be very careful with that.

But as Dennis said, it is a great way to make income, depending on what you do with the underlying security. Dennis, what are your thoughts on that?

Mr. Gibb: I agree with you. We tell it to clients this way: If you are getting ready to sell some stock for whatever reason, either to take advantage of capital gains treatments or whatever — let's say the stock is at $25 and it is a reasonably volatile stock and we can write a call at $30 and we can take in $2 — we tell them, “effectively you are selling the stock at $32.” So, what we try and do if we are getting ready to sell stock is either write in a money call — which guarantees us a sale — or we can write it close to the money call, which will gives us a little bit of a higher sale and brings in some income, and at the same time gives them a horizon. So you are right. We have to look at what the client wants to do — you don't want to write a three-month option and have the client sell the stock the next month.

Typically, this is all stock that we have in the clients' accounts, and we know where it is and we can see the action in it. And they can do whatever they want. I think covered calls are a fairly simple technique to use and it is fairly simple to understand. You just have to put some parameters on when you are willing to use them.

InvestmentNews: Joe, any thoughts on that?

Mr. Burgoyne: The only thing I would like to add is that volatility is key when you are talking about covered calls. There are two kinds of volatility at play. There is historical volatility, which is how much the stock moves. Then there is implied volatility, which is the expected amount of movement that the stock will have in the future. So you may write a call one period and get, say, $1.50 for [an amount] of the money at a $30 delta, and six months or a year later you may get $2.50 or you may only get 50 cents, and what has changed is the level of implied volatility. I think it is pretty darn important, I'm not sure if Ken and Dennis agree, but it's worthwhile to have a general sense of where that implied volatility is when you are doing covered calls.

Mr. Gibb: It's also important to consider is the number of earnings cycles. Know what month a company's earnings are coming out, because that will unquestionably affect a level of implied volatility in those options.

InvestmentNews: How much time does it take to manage clients' portfolios using options? Do you have to be constantly watching the options?

Mr. Gibb: It doesn't take any more time to do this than it does to do anything else. If you are like a lot of advisers, over time most of your portfolios end up containing pretty much the same securities. So if you are writing against portfolios, you are going to end up looking at the same securities every day. And it doesn't take any more time to watch a portfolio full of options. With modern technology, you can set alerts to alert you constantly about what is happening with options. And most of the trading platforms now allow you to put trailing stops in and do all sorts of things. So you don't have to be sitting there, watching every day, to do this stuff.

Mr. Burgoyne: I would second Dennis' comments. That is the feedback I get when I am out talking to guys in the field all the time. The platforms make it very doable.

InvestmentNews: Do you need to be doing this on a discretionary basis?

Mr. Gibb: Everything that we do here is discretionary. But when I was a broker, it made it a little more difficult, if you had to call the client every time. If you can get discretion, it makes it a lot easier.

Mr. Winans: I would second that, and add that when you are dealing with new clients, they clearly need to understand that things are fast moving and the opportunity might disappear very quickly. In the RIA world, discretionary is a better way to go.

InvestmentNews: There is a question, from the audience: “Is there any software or illustrations that can explain — visually or in plain English — puts and calls and bear spreads and this stuff, where advisers and/or their clients can actually see what is happening?”

Mr. Burgoyne: At our website, we have a simulator where you can put in a particular position and watch it over time change in graphical and [profit-and-loss] form.

InvestmentNews: And can clients look at that, too?

Mr. Burgoyne: No, that would be for the financial advisers.

InvestmentNews: But is there anything that the adviser can use to show to the client?

Mr. Gibb: I have looked around at this stuff and there are a couple things out there. I'm fortunate enough to have Bloomberg. Now, Bloomberg has a very aggressive options platform where you can put up simulations and you can vary volatilities and you can do all sorts of things. But most people aren't going to pay $1,900 a month to get that.

A guy by the name of Peter Hoadley [hoadley.net] has a simulator, an options issue, where you can actually put this thing up and it shows you P&L, it shows you graphics, you can change volatility, you can put dividends in. It is pretty sophisticated. You can get a free version of it, or there is a licensed version. And the licensed version gives you real-time quotes and real-time information. And I have found that to be a lot easier to use with clients when they come to the office: sit them down and run this thing through Hoadley, because it doesn't get as complex as Bloomberg and it does a little better job of explaining. And the other thing about Hoadley is that his software already has all of the strategies built in. So if you are doing something on Microsoft and you want to do a bear spread, you type in Microsoft, you go over to the right column and hit “bear spread,” and it populates, gives you the proper strategy, gives you the buy and sell, buy call/sell call, or whatever. And then it has got them in different ways so you can put that up there and then you can look at it. And you can print some of this stuff off. You cannot e-mail it but if you have a client sitting at your desk or in your office, you can put this thing up and it is pretty slick.

Mr. Burgoyne: I may have misspoken a little bit. FAs certainly could use our simulator on the site, it is free of charge. The customer could then go home and go into the site themselves and use the same simulator. I don't know if that is just the write application, but it is available to all investors.

Mr. Winans: We use MetaStock for a lot of the research. MetaStock has an actual edition called Options Scope. I have been using it for years; it is a very reliable program.

InvestmentNews: Another question from an adviser: “I often hear from prospects of clients who say, "My current financial adviser at a big-name firm doesn't use options. If it is so effective, why wouldn't most advisers use it?' And I am trying to come up with a good reply.”

Mr. Winans: Realize that the wagons have been circled at the big brokerage houses. I find it funny/sad that many of these same FAs are not allowed to use inverse ETFs right now. They have just been saying, “No, you can't use them,” because a handful of people did something phenomenally stupid and blew up a portfolio. And as Dennis brought up earlier, we are talking about reducing risk, not becoming a bunch of gunslingers. But the client shouldn't take it as personal. The firms have made a decision that it is too dangerous and creates too many lawsuits. There have been too many people who have gone out there with wild gambling strategies that have lost money. But I think it could be convincing if that person can turn around and say: “That is why you need to work with an independent adviser. I don't have the kind of governors placed on me that those big wirehouse advisers do.”

Mr. Gibb: I would agree with you 100%. I think there are two big reasons that it isn't being done. One is that there are a lot of compliance issues involved. The second is many people don't have the time to sit down and look at it. But it is not that hard to understand, and it is not hard to do. I have to admit, I have been doing this for 40 years. And sometimes when people show me options strategies, I sit there and go, “No, I don't understand this; I can't make this work.”

Mr. Burgoyne: We offer a live call-in desk, five days a week. We have option professionals there free of charge to take any phone call.

Mr. Gibb: One other thing is, look at the resources within your custodian and your own firms. One of our custodians has a desk for special transactions. And I call them up and I say, “Look, here is what I am looking at; can you help me?”

InvestmentNews: Joe, what percentage of brokers use options?

Mr. Burgoyne: I think it is in the 10% to 15% range.

InvestmentNews: Any idea on the adviser's side? I guess it is hard to tell.

Mr. Burgoyne: I think it is at least [10% to 15%], but it is hard to tell.

InvestmentNews: Dennis and Ken, what kind of comments have you gotten from clients? Are they surprised by the kind of extra income or protection you can offer?

Mr. Winans: The No. 1 thing I find is the mass media. They will have seen some scattershot person on TV who said that all options strategies are bad or evil or whatnot, and you find yourself having to fight these broad statements that just don't pertain to their situation.

But I think it is like anything else. Whenever there is something new, start small, show people how it works and let them tell you how comfortable they get with it. Because the last thing you want to do is to have a big client leave because some part of their portfolio didn't work according to plan.

Mr. Gibb: A quick story: In 2001, I got asked by an attorney here in Seattle to give expert-witness testimony in a case of a husband and wife who worked at Microsoft and had gone to a big brokerage firm. The broker had advised them to write a collar on their Microsoft position and they turned him down because it took away their upside. They wanted to be protected to the downside but they didn't want to give away any of their upside.

The broker was smart enough to have written them a letter saying, “This is what I think you should do” — so on and so forth. The stock ultimately collapsed, and they sued the brokerage house. I got asked to come in as an expert witness. I looked at the case and I said, “No, the broker did 100% right.”

What you had here were two crybabies. They made a mistake. They didn't do what their broker told them to do. The broker told them to do exactly the right thing. They chose to play games with it.

I did a lot of put selling in October and November of 2008. And I want to tell you something, I had people bringing me bottles of wine the next year because when this market took off in 2009, people had these stocks that they bought at these ridiculously low prices. And I generated income for these people and it has made a lot of difference. I've never had a client yet who wasn't happy with what happened with options. I mean not 100% happy — sometimes it doesn't work the right way — but most of the time they are very pleased with what happens as long as they fully understand what it is you are trying to do for them.

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