Options: The logic of puts and calls

The following is an edited transcript of the webcast “Managing Risk and Boosting Income Through Options,” which was held Feb. 23. Deputy editor Evan Cooper and senior editor Jeff Benjamin were the moderators.

InvestmentNews: Eric, what do you see in your travels around the country educating advisers about options? What’s the mood and how has options use increased?

Mr. Cott: The Options Industry Council is a not-for-profit consortium representing the nine ex-changes in the [Options Clearing Corp.], and our mission is strictly about education for individuals, institutions and financial advisers.

I’m sort of the preacher, minister and rabbi of options, and my congregation is the entire 300,000-plus wealth managers spread across the U.S. But the OIC is agnostic in that we spread the gospel by providing free resources and educational outreach.

I believe the majority of financial advisers are starting to think outside the box in terms of the word “derivative” and instead embracing the mentality of how to provide risk mitigation and risk management to their client base. This is how advisers should consider implementing options in their practice.

Financial advisers are beginning to become proactive, not reactive, in terms of incorporating options as a part of their overall asset allocation models. I’m pleased to say I have noticed as I travel around the country that a growing number of advisers are beginning to realize the value that option overlays can offer their clients, whether it’s protecting profits, hedging against market volatility or just seeking to add some income in an environment where it’s hard to find yield.

As a former producing manager, I’m sort of empathetic about the issues that are raised when advisers discuss options strategies with their clients. Clearly, the debacle of 2008 — when non-correlated became correlated — and the flash crash of May 2010 have played a role in convincing advisers that they just can’t ignore options and only focus on the buy-and-hold. So there is an appetite out there for advisers to start to learn about this, and we have seen a tremendous increase in terms of registration at our website, but also for the advisers to understand that their clients are coming out to our free education. That’s driving the volume and interest in adding options to their practices.

InvestmentNews: Michael, we’re going to ask you to answer the first question that came in from the audience, which is, “What is an option?” We’re going to go from that to more sophisticated techniques and strategies. But you’re in this every day, so tell us a little bit about what options are and how advisers can use them in a way that makes sense.

Mr. Cavanaugh: Absolutely, and there’s no perfect way to answer that question in an hour. It’s the right, but not the obligation, to be long or short of stock at such and such a time, at such and such a strike. Without getting into the textbook definition, what I think the importance of an option is, and what has been somewhat of the mystique of options, is important to say before we get into options.

I’ve given seminars across the country, and when you tend to say “options” to a group of people that don’t understand what they are, you see a wince, and the reaction is usually, “Well, those things are too risky for me.” It comes from the advisers’ side as well as the clients’ side, and I think there’s a misunderstanding that options were actually created to hedge risk and give you the potential to add income to a portfolio.

As a money manager, I tell all of our clients that if they are the family chief financial officer or if they have jobs as money managers, their core task, whether they know it or not, is to seek alpha. [It’s their job] to go after alpha in a portfolio; to bend, but not break, a client’s portfolio by trying to make more money, while at the same time not losing sight of risk and trying to risk less. That’s our job, whether you’re doing it on your own for yourself as a client or you’re doing it as an adviser.

OPTIONS 101

So how do we do that with options? The first thing you have to do is understand them. Eric mentioned the OIC advisers site. That’s a great place to get free objective information. And there are different portals whether your broker-dealer provides that kind of information. I’m lucky enough to have a B-D that has an education portal and different things available.

But where this gets you is, if you use options the right way to hedge risk, you’re looking at ways that you can differentiate yourselves from other advisers at a time where differentiation has never been more important. The buy-and-hold strategies have come under question here lately and a lot of questions are coming from the client side to where people are looking for ideas.

When certificates of deposit are paying less than 1% in some cases, people want to add income, and the very non-complex way to do that is through a covered call. When you own a stock and you sell a call, you can sell the stock at a price at which you preset the level.

What I compare a covered call to, in layman’s terms, is, if you own an apartment and you don’t live in it, would you let it sit there and hope that it increases in value? It’s one strategy. But if you can rent the apartment out while you’re waiting to gain on the increase in value, why wouldn’t you do that?

And you can do the same thing with the stock. By owning the stock, you can sell a call each month, or every two months or every three months, where you have an income coming in, where you have the potential to give the stock away or the apartment building away at a price that you’re OK with selling it. So you get a little bit more bang for your buck. It’s not a complete downside hedge by just selling the call, but you’re getting a little income from it, and over time, it starts reducing your cost basis. You have the potential if the stock does go up and you get called away that you’re locking in a price, locking in a ceiling of profits. As long as you’re OK with that price, your opportunity cost is just that you didn’t make as much as you could. The benefits of the strategy are that it reduces the implied volatility in the return.

Mr. Cott: On the covered call — and Mike really raised a good point — one of the things is that the options world shouldn’t be a foreign place for advisers. I realize as a former adviser, it’s a bit intimidating at first, but all the advisers out there are great at what they do, so there’s no reason they can’t get comfortable with utilizing options strategies.

A colleague, options guru Dan Sheridan, has said, “It’s important to recognize there are a lot of moving parts in the options world versus the equity world.” It’s very clear that education, patience and setting goals are only one piece for an adviser. There are other factors that they must consider. Those factors are the price of the underlying investment, the time to expiration and implied volatility.

Mr. Cavanaugh: If our job is to risk less and make more. A covered-call strategy is a good way to accomplish that task.

EVALUATING THE CHOICES

InvestmentNews: Larry, tell us a little bit about what you do, and tell us how an adviser can figure out whether buying options makes sense for them.

Mr. Cavanagh: Let me say a quick word about Value Line [Inc.]. It’s a company that’s been in business for 70 years, and we’ve actually had an options service since 1973. What we do at Value Line on an equity basis and on an options basis is, we look at the entire market and make comparisons. Our job is to look at the entire listed equity options market and come up with evaluations based on numbers alone. There is very little subjective input when we make our estimations. So we use statistical models and then we use the very same Value Line option ranks to come up with our evaluations.

At least in terms of the options we rank, we try to put them in a distribution where, say, the top 7% will be the most recommended and the bottom 7% will be the most recommended for taking the other side — that type of thing.

So that’s what we do. It puts us in a nice position with a product — available on a retail or small-level institutional basis — that really has an evaluation on every single option out there. So if you’re sort of curious about what the covered call on a particular company is on a particular day, we have a particular evaluation of whether we think it’s cheap or expensive and what the yield would be, etc. So that’s fairly helpful.

Getting back to your question about how this might apply to the actual adviser, I think there are a number of things the adviser wants to do. The adviser should look at the types of stocks that clients have in their portfolios and the type of investment styles they want to pursue, and build their options strategies around those characteristics.

In other words, if somebody wants to hold a portfolio of stocks that they’re going to keep for a very long time, then one would be fairly defensive in terms of their covered calls; writing them for income but not having them called away and at the same time probably putting on put hedges only when they’re cheap or inexpensive — that type of thing. If somebody is a lot more aggressive and wants to play the market in certain ways, rather than trading in and out of stocks or doing large index trades, one can use the options to take advantage of the various swings in the market one way or the other.

InvestmentNews: Eric, maybe you could explain some of the terms Larry used — volatility, put strategies and such. Just give us a little bit of the layman’s explanation of some of those things.

Mr. Cott: Sure, and again, Lawrence has mentioned some key strategies, especially in this economy right now. Again, the problem I think for advisers a lot of the time is that they have sort of two important things in their lives. No. 1, it’s their family. No. 2, it’s their clients. So it’s hard for them to learn a lot. There are 90-plus different strategies in the options world, and I think when they focus on their client book of business, it’s hard to learn them all.

In an environment like today, how do I add extra income? That’s where the covered call with a buy right tends to be a useful strategy. We’re talking about put overlays or protective puts; that’s simply insurance, as Mike talked a little bit about, and Lawrence, as well. We’re seeing huge, huge gains in the market as clients’ accounts have gone up. Well, if we’re a little bit worried about a drop, maybe another trough, maybe a flash crash, maybe we start to look at putting a protective put.

I think two things I want to mention: I’m just going to define “volatility” in layman’s terms. Volatility could be your friend or enemy and I think it’s important for advisers to know that. There are two different types of volatility: First, there’s historical volatility and that involves determining whether the option is overvalued or undervalued. Then, there’s implied volatility, which is the expected amount of movement that the underlying investment will have in the future. So in general, implied volatility increases when the market is bearish and decreases when the market is bullish. So it’s important we look at options for your clients.

The one thing that’s critical — and the OCC does a great job about this — is that your client cannot trade options without first receiving what they call “the characteristics and risk of standardized options” document. So it really defines the industry in that it explains the risk and rewards even before you jump in with your client. So that’s something that I believe gives you the comfort zone that you’re just not immediately executing a trade for your client. You’re actually sending them a document to explain all this terminology about covered calls, and risk and reward, etc.

COMPLIANCE ROADBLOCKS

InvestmentNews: Very often, brokers — whether they’re employee brokers or independent brokers — are limited by their compliance departments as to what they can do. Do you run into that a lot? How much can an individual adviser actually do in options?

Mr. Cavanaugh: I think it varies from firm to firm. If this is something you are doing, or interested in doing, it’s imperative that you have a broker-dealer or custodian that is able to execute that. Not just in a regular, non-qualified account but in qualified accounts, as well. It gives you the ability to reach a larger source of potential clients, and service your current clients in a good fashion. Some broker-dealers do set limitations, and I think the limitations might just be from an understanding of what options are used for.

So it’s definitely imperative that you have a broker-dealer/custodian that is familiar with options, not only in the front-office role but in the back-office role as well — that they have a network of operation people and a network of other advisers that you can be in touch with to share strategy ideas, to clear the trades, to do it in a manner that makes your job easier, to leverage the technology in a group-trade fashion if you’re handling more than one client and one strategy. So there are a number of option-friendly broker-dealers. My broker-dealer has been great with the options side of the business. It’s something that you have to have in place before you get into options.

InvestmentNews: Let’s go back a bit to make sure we’re covering some of the basics here — maybe starting with Eric and talking about a specific example. Let’s say a client owns 100 shares of General Electric Co. and you want to put a basic option collar on that position. Can you explain specifically how that works? Because there obviously are costs involved here, too.

Mr. Cott: That’s a great point, actually, because any example we’re talking about doesn’t include commissions. One of the elements that a lot of advisers bring up to me in the field is that there’s a cost involved in that, and then, “How do I make this scalable?” The point of compliance is also critical, and Mike touched upon this. Every firm is different — whether it’s an RIA, independent or a wirehouse firm — and I think it’s important to provide feedback to us at the OIC about some of the objections you’re getting or some of the difficulty in wanting to employ options strategies at your firm.

FIRMS MORE FLEXIBLE

More and more firms are realizing that they cannot, in this day and age, restrict their advisers from doing anything. You’re in a more difficult situation as a buy-and-hold investor than you are with an overlay. It provides you a lot more flexibility.

As to your question about utilizing a collar on GE, well, I believe if we’re talking about an adviser out there who’s maybe working with an executive at GE and they’re talking about a collar, in simplistic terms, they’re talking about marrying the call and the put together. And that strategy is going to work if the client agrees with their adviser that, “Look, I’m going to give up some of the upside to protect my downside.” Is the client comfortable enough with potentially having the stock missing an upward rise?

InvestmentNews: Could you explain what part of the collar actually limits the upside and what part is the call? How does that work?

Mr. Cavanaugh: The part of the collar that limits your upside is being short the call. So when you buy an option, you have the right, but not the obligation, to exercise on the third Friday of set month that you own the option. When you sell the option, when you open the position as a short option position, you’re waiving your obligations and your rights to exercise. You’re obligated if the person on the other side decides to. So if the stock is trading at $50 and you’re short the $55 call and the stock is trading at or above $55 on the third Friday of your expiration month, you’ve given up your upside. So anything above that $55 strike of the call that you’re short, you’re no longer participating in the upside.

So the great thing about a collar, and Eric was hitting on this, is if you have a client with a bunch of a stock on which you can define a floor, saying, “Your stock will not be worth less than X, because you own the put, and your stock is never going to be worth more than X, because you’re short that call.

It gives you the flexibility to create that floor and ceiling, and it gives you the ability to manage that relationship with the client where they know that if they open up the paper or turn on CNBC, they’re going to see, oh, this stock is in the headlines. They know on the third Friday of the expiration month of the strategy with the collar that they’re in, that they have a floor and a ceiling. That manages two things: It manages the expectations of the returns or the losses in the account, and it manages the client’s emotional reaction to opening the paper or turning on the news. They know what they’re up or what they’re down. A lot of times, an emotion-charged decision tends to be the wrong one, and if somebody doesn’t have that managed floor and ceiling, it can be hard.

InvestmentNews: Obviously, nobody cares about how high a stock goes, but don’t you sell the call to help pay for the put?

Mr. Cavanaugh: Exactly. That can help finance the cost of the put.

InvestmentNews: Someone who owns GE is happy about being protected on the downside but really doesn’t care if it goes to $1 million.

Mr. Cavanaugh: Sure, because you’ll never have clients upset with you because they didn’t make more money.

InvestmentNews: Are there scenarios when it would make sense to just buy the put or sell the call, for example?

Mr. Cott: In a zero cost collar, we’re using the premium from the call to pay for the put. Look, the Dow has gone above 12,000. We’ve seen tremendous gains in Dow stock, companies of the Nasdaq. I have an umbrella policy in case my postman slips on the ice with 70 inches of snow outside my house. Thankfully, I’m not using it at this point, but I understand what insurance is. It’s the same conversation advisers should have with their clients. We have unprecedented gains. The market could go back to 2008. So if we look at the market right now, volatility is spiked a little bit. But when premiums are cheaper, it’s the time to have a conversation with the client about saying, “Hey, maybe we should buy insurance on that stock in case things go the other way.”

InvestmentNews: Eric, let’s say you have a $50-a-share stock, you have 1,000 shares. How much would it cost to “insure” it through options? About how much would just the pure insurance part cost through options for something like that?

Mr. Cavanaugh: Well, that’s going to be a function of the volatility. Without naming individual issues, let’s say XYZ stock is trading at $50. Right now, a $50 put two months is trading for about $1.50. So if you have 1,000 shares, that’s 10 contracts, it’ll cost about $1,500 to insure XYZ stock with a volatility relative to where it is in today’s terms.

InvestmentNews: And more volatility makes these options more expensive, correct?

Mr. Cavanaugh: Correct.

Mr. Cott: Right, and that’s the point we were talking about. An adviser doesn’t need to become an expert in it but should understand the difference between historical volatility and implied volatility when they start to look at options. Because that could have a negative impact when they initially talk with their client about a strategy, and all of a sudden, the client says, “Wait a second, that’s not what I wanted to have happen.” You have to have that goal in mind with the client that this is why we’re utilizing an overlay, or why we’re doing a protective put, why we’re doing a covered call.

InvestmentNews: What’s an overlay?

Mr. Cott: An overlay is just terminology saying we’re going to use a protective put. We own stock in XYZ, and we’re going to basically do a protective put on that position — with the concern that if the market goes down, we have the right to deliver the stock. We bought insurance.

InvestmentNews: We’ll go back to the example of the $50,000 worth of stock that costs $1,500 to insure, and you can say whether that’s expensive or inexpensive to buy that. Is that typically what you would do, Lawrence? How would an adviser determine if it’s worth it?

Mr. Cavanagh: I believe Eric mentioned so-called historical and implied volatility. You look at past volatility, and what we do is we look at the big picture. We look at a seven-year history of stock price movements and we try to figure out, based on that type of history, whether this option is cheaply priced or expensively priced, based on given volatility levels.

You also have to look at what you’re insuring against. When you own a stock and you hedge it by buying a put, you’re partly protecting yourself against a loss if it goes down, but you’re also protecting yourself against having to worry about the fear that you might have. In other words, you’re protecting yourself against being wrong in both directions. If you own [a stock] and you say, “I’m a little worried about this and I’m going to sell it,” but then you’d say, “Well, the hedge is fairly cheap.” Then, you’re really protecting yourself against being wrong after the fact if you did sell that stock. You’re protecting yourself against being wrong in both directions.

BREAK-EVENS

So you have two break-evens. You have a break-even above the price you paid for the put. If the stock goes higher, you’re going to say, “Gee, I’m glad I held on to my stock and bought that put.” And if the stock goes lower, below the strike price line of the premium, you’re going to say, “Gee, I’m glad I hedged that position.” So you have a very broad range of outcome. If you buy that cheap insurance, you’re going to be right after the fact, and you’re going to look pretty good.

InvestmentNews: Eric, you wanted to say something about how people can test this out, and the OCC has something that’s helpful, right?

Mr. Cott: Lawrence mentioned a couple of good points. I believe there are different markets and errors, and again, it comes down to the adviser and client figuring out, “Is this the appropriate strategy for us right now?” One of the things about the website optionseducation.org/advisor is that we have a strategy screen as well as calculators, etc., that allow an adviser to go on and download a portfolio and practice without real money.

And I think that’s a comfort zone that advisers like, because maybe they made a mistake 10 or 15 years ago when they were using options, and something got called away before expiration, which I think is an important point to bring up on this call. You have an expiration, but advisers need to know that they can be assigned early. And so maybe you had a mistake with a client and you said to yourself, “I’m not going to look at this again, because it was such a bad experience.” That shouldn’t be the main cause as to why you’re not discussing it with your client, because advisers have never been more vulnerable [to clients’ leaving] than they are today.

And if your client is calling you on the phone and asking you about maybe doing a buy right, a covered call, or talking about a collar because a work colleague’s adviser started to talk about that because of the rise in the market, don’t send them down the street. Because I will tell you from my experiences around the country, you’ve never been more vulnerable in telling your client to go do something away from you.

InvestmentNews: Eric, you’re doing some research on the adviser market sizing, with the options industry, correct?

Mr. Cott: We are. We’re in the throes right now and I hope to have the study done by the end of the second quarter. But the Options Industry Council, again, I work for the OCC, the Options Clearing Corp.; the OIC is representative of non-exchanges and the OCC. We’re in the process of using a third party to conduct what we believe is the first of its kind, and it’s going to be a quantitative study of advisers’ use of equity options with their clients.

Every five years, we poll clients about their use of options and it always comes back every rolling five years that more and more clients are using options. This is actually the first study that’s going to be targeted just to advisers and advisers that are using options.

InvestmentNews: Can you, Eric, or maybe Larry or Mike, give some perspective on what you’re seeing as far as the growth of options over the past few years?

Mr. Cavanaugh: Just in equity option volume from 2001, we’ve seen seven times growth on the exchange level. So if there were 2 million options traded in 2001, there’s 14 million traded in 2011. Those aren’t the exact numbers, but the growth is seven times in that 10-year period. And what I’m noticing with the advisers, when you throw these numbers at them, they say, “Hey, our clients are learning options and they’re pressing us to differentiate ourselves to help them risk less to make more.” And what I find most advisors saying is, “Wow, this was a great seminar, this was a great webinar, but I’m going to leave here after an hour of getting pummeled with statistics and ideas about how to sell calls and do collars. And how do I actually leave this seminar and start doing this?”

Eric mentioned the strategy scan on the Options Education site. My broker-dealer, brokersXpress [LLC], has a virtual-trade practice simulator. So you get the education from an OIC, you get the virtual trade from a firm like brokersXpress, and then you start with your own money, or a client that you’ve had for a while that is suitable for the strategy, and you start small while you’re educating yourself. It gives you a great shot at learning the right way where you’re not forcing it on everybody, but you’re learning as you go. And I call the learning experiences “uh-ohs,” as in: “Uh-oh, I didn’t know that could happen.” You’re better off making those small mistakes while educating yourself with the virtual trade or from reading about it versus finding out something that you’re leaving and doing it on a macro level.

InvestmentNews: Feel free to mention or list the websites. Advisers are going to be interested in following up with those. If you could mention them right now, it would probably be helpful.

Mr. Cott: It’s optionseducation .org/advisor, and one of the things that’s coupled with that that advisers should know is that there are three different portals. We have an institutional portal. We have an individual-investor portal that’s for their clients. And a number of years back, we created one just for financial advisers. And on the home page as well there’s a telephone number, (888) OPTIONS, that advisers should feel free to use. I encourage them to do this. All my colleagues and specialists are there, five days a week, if advisers ever have questions. This is a free service. They can ask any question, and it’s just a great resource to complement what they might have at their firm already, to sort of try something out. They might be looking at six-month calls on a specific stock, or at the premium, and saying, “I’m a little uncomfortable. Maybe I should be only going three months. I’m looking at it again.” And I believe we talked a little bit about this in the beginning of the conversation, we have in the money, at the money — different strategies on how an adviser is going to look at what contract to incorporate when they’re talking to their client.

REACHING OUT

InvestmentNews: So can an adviser call and say, “I’m thinking of doing X and Y. Does that make sense?” and the person on the phone will go through it with them?

Mr. Cott: Absolutely, and they love to talk to advisers. They get a lot of phone calls from individual investors, but they only ask you, I believe, your last name and ZIP code or your first name. But as I said at the beginning of this call, we’re agnostic, so we don’t release any of your information. But try the service out, give them a call and let them know. Say, “I’m looking at a specific stock right now and I’m looking at doing a protective put; I just don’t know what series to look at. I’m trying to figure out about the premium and I know there might be a dividend play here.” And they really do talk in layman’s terms and they’ll spend as long as you want on the phone.

InvestmentNews: How are the gains and losses from options trading taxed? One of the attendees had a question. He asks, as the devil’s advocate: “If you owned a stock for a long time and have a big gain in it and it is called from you, you could take a huge tax hit that you might not want. Is that correct?” It seems like the strategy would work better for short-term stock holdings, and he wants to know whether he’s right or not about that. So let’s talk about taxes and how that affects options trading.

Mr. Cavanaugh: Even though I’m not allowed to give tax advice, there are some things that you definitely need to be aware of. More specifically, with the collar strategy, it can reset the cost basis when you buy a put on a particular stock. So once the put is gone — if it expires worthless or if you exercise it — the cost basis then resets, and then if you hold it for 12 months, you go back to the long-term capital gains. So it’s definitely something that you want to make sure you understand from the tax side of things so you don’t make an “uh-oh” and learn something the hard way where it costs your client a different amount of money than what they expected. You definitely want to consult a tax adviser or your firm’s IRA/tax department before you incorporate any strategies in which you think there might be an unwanted tax event.

InvestmentNews: And even if you don’t think there is one, consult it anyway because there might be one. Eric, you wanted to say that Ernst & Young [LLP] has a tax guide that’s on the OCC website?

Mr. Cott: That’s downloadable on our website. Most firms have that guide already; I mentioned the characteristics of a risk document which has to be sent to every client before they do options. The tax guide is in the process of being updated, but we have that. And then as Michael mentioned, it is imperative that you talk to your compliance officer or a tax adviser when it comes to that. Tax laws are changing all the time now. There are very few firms out there that allow you to do option trading in a qualified account, but I think there are more firms that are offering that. And you know that removes some of that issue when you’re doing it in a qualified account versus a non-qualified account.

InvestmentNews: There are packaged products out there, mutual funds that do this for you. That’s something that I think advisers or any investor could try. There’s a Buy Right Fund, I think it’s called. Anybody know about those mutual funds that offer this kind of strategy for you?

Mr. Cott: We have profiled on our website a couple of them. There’s an open-end mutual fund out there that has a collar strategy. I can’t really mention specific third-party providers — maybe Lawrence and Michael can — but there are different opportunities out there. And I believe that’s what’s going to increase the use of advisers in doing options — when they could seek out separately managed account managers or ETFs or third-party providers who are offering them the daily maintenance of doing these option strategies so they can focus on raising assets. So I’ll turn it back to my colleagues.

ACTIVELY MANAGED FUNDS

Mr. Cavanaugh: Eric said that he can’t mention names. I know a couple of guys that have open-end and closed-end actively managed mutual funds. It’s not what’s better or what’s best; it’s what’s the best for you and the management of your time. So sometimes an open-end mutual fund is a good alternative for somebody who manages a lot of client relationships and doesn’t have the time for self-education. There are a handful of actively managed open-end mutual funds that incorporate option strategies. If you do have the time to learn and educate yourself, it gives you the ability to cut down some of the expenses to the end-user, which is your client. You’re not going to make all the money in the management of an open-end fund, so you’d probably be making the same amount of money as the fund adviser. Your client would be charged less, so that would be the win there if you’re able to have the time to leverage yourself, to educate yourself and take matters into your own hands.

InvestmentNews: Would you consider a mutual fund that uses an options strategy as sort of a foot in the door or a way to at least explore it and study it and watch it?

Mr. Cavanaugh: It’s tough to say, because you really don’t see what the inner workings are. You’re given an explanation and you’re given a prospectus that says, “This is what happens,” but you can’t physically see it. I would encourage that if you do invest in one, you have some kind of virtual-trade apparatus. And I didn’t mention the site before, brokersXpress is brokersxpress.com. It has a virtual-trade apparatus. If you can see it and watch it move in the open market, you’ll start gaining the better understanding of it.

InvestmentNews: From an investor’s perspective, was there a difference between having your adviser running an options strategy on some of your positions and your putting your client in one or two of these mutual funds?

Mr. Cavanaugh: From the in-vestor’s perspective, it would create a tighter bond between the client and the adviser. They would be communicating more and some advisers may not want that, but it would create a tighter bond.

InvestmentNews: So you, yourself, would create the tighter bond.

Mr. Cavanaugh: Exactly. You tell your clients, “We’re going to put 2% to 5% of your money in this actively managed mutual fund that has an options overlay as part of the strategy.” And they say, “Well, what’s that?” and you start seeing how it operates and maybe that’s something where it gets some interest. And they say, “I think you and I as a team, adviser-client, we can do better.” So it’s definitely an eye-opener. It’s a good entrée to get people engaged to learn to help them hedge their risk.

INDEX OPTIONS

InvestmentNews: There was a question about index options. There’s really no difference between an index option and the single-security option, correct? It’s just that you’re buying and selling the options on an index, right?

Mr. Cavanaugh: There’s a difference in the taxation of an index option. It’s a Section 1256 contract on the cash-settled, broad-based indexes. So there’s a taxation difference and then there’s a settlement difference. There is what they call a European-style option and then an American-style option, and most of the index options tend to be a European settlement. Before you or your client sign up to trade options, you should read the options disclosure document and understand the differences between a regular index option and an ETF option, versus the American versus the European.

InvestmentNews: There is such a thing of buying and selling options without owning the underlying security, right?

Mr. Cavanagh: There certainly is, and often that can be a very valid strategy. For various reasons, you might want to hold your money in cash and buy a call instead of buying the stock. And if you calculate the amount of cash you hold as equivalent to the strike price value of the call, it turns out to be exactly the same outcome as owning the stock and buying the put and hedging it. The other point is that buying options like calls — or puts, for that matter — can give you a leverage that can be very important under certain circumstances. It may not be something you want to do every single day, but it may very well be something that you want to have your clients reasonably prepared to do when they have to or when they need to do it. And there are all kinds of reasons why they may want or need to do that.

InvestmentNews: Is that a lot more risky than owning the underlying?

Mr. Cavanagh: There’s a lot more leverage, which can make it riskier, but there’s not more risk as such. In fact, it’s virtually the same. We have what we call in the business a “cash-covered put,” in which you put down the cash equivalent to the strike price value of that put option. In other words, if the strike is $50, you put down $5,000. And if you calculate those returns and those outcomes, it’s going to be exactly the same as a covered call, and this can be a more attractive strategy under certain circumstances. It certainly can be more attractive if you want to take advantage of premiums that are actually below the stock price, in which case you can be writing the various puts on these various stocks and picking up the premium, and not having the issue of getting called away and having to be exercised. So, it’s a very nice strategy.

InvestmentNews: A specific question, and then a general one. The specific one is one from an adviser, who asked, “I have 160 clients and it would be a nightmare to keep track of 160 options positions for all of them. How does that work in practice? This is more than just buying whole. You have to watch this stuff, so what is an adviser supposed to do?”

Mr. Cavanaugh: We’ve got more than 700 clients and we manage more than 10 different kinds of option overlay strategies. So we approached our broker-dealer and said, “This is how we need it managed,” and they’ve given us an open architecture of a group-trading, average-price-trading platform that allows us to preselect a number of contracts. We put the trade in once. If it gets filled at separate prices, it average-group prices everything. It allocates it to each account and then we simply have to review each account by the end of the day to make sure the allocations were set. Then we just monitor the position as one, and every time we have to make any kind of adjustment to that trade, we’ve got the preset allocations ready to go.

InvestmentNews: So an adviser says, “I’ve looked into options, and I think they’re a good idea, but I really can’t devote the time it takes to watch all this stuff. Can I turn it over to you to watch it?” How does it work if they wanted to say, “I know enough that I know I shouldn’t be doing this all the time, but I want somebody who knows what they’re doing to do it.” How does that work?

Mr. Cavanaugh: They would either have to have somebody on their team that was able to monitor it, or work with a subadviser who’s able to monitor or manage an options overlay for them.

Mr. Cott: That’s one of the things that a lot of advisers in the field bring up, and I think that’s why the question came out. It’s not scalable. I have way too many clients. Again, I talked about the idea, you know, you have your family and your clients. There’s not enough time left in the day. So there are opportunities for asset managers and separately managed account providers to come up with ways to provide overlay strategies for advisers to use options in a managed account. So if you have a team, you might have a dedicated person, a portfolio manager on that team, who is just overseeing the option strategies.

InvestmentNews: An adviser asks, “If there’s one fiduciary standard for everyone, brokers and advisers, where would options fit in? It might eliminate some of the “riskier” strategies, but it might mandate that advisers do certain things to mitigate the risk.” What’s your view on that, each of you?

Mr. Cott: Without getting into a political objective here, look at what happened with advisers who had a buy-and-hold strategy from October of “08 to February of “09. They were like a deer in the headlights, and they just sat there not doing anything for their clients, whereas the advisers who had the foresight to look at options strategies had a lot of happy clients.

InvestmentNews: Mike, what’s your opinion on that?

Mr. Cavanaugh: I came from a different world of advisers. I was a floor trader at the Chicago Board of Trade, and I would argue that as an adviser, part of the fiduciary responsibility is to help your clients individually, client by client, to determine what kind of exposure they should have in the equity or the bond or whatever market it is. And say, “We have upside but we’re going to need insurance.” And the thing that has always baffled me is, we have life insurance, we have insurance that insures our cars, our homes. But as a fiduciary, don’t we have the responsibility to educate our client, to say, “Right now, you’re not able to just take blind risk in the market. We need to insure ourselves if the market were to correct. We don’t want you in a position that you can’t afford”?

So I’m sure it’s a very sensitive point because the perception has always been that options are risky. Options were created to hedge risk, so when an adviser is acting as a fiduciary, incorporating them into people’s portfolios could be a breach of fiduciary duty if you don’t get to understand options.

InvestmentNews: Any final words from anyone?

Mr. Cavanagh: I think just about everything has been said. I love the tools at brokersXpress, by the way. So I’ll just add that.

InvestmentNews: Mike, what are your last thoughts?

Mr. Cavanaugh: Our website is out there, knowyouroptionsinc.com. We’ve always kind of held ourselves out there as ambassadors. So any adviser that wants to get in touch with us, ask us any questions, we’ve got an open line here if people want to understand options. And Eric’s site is great as far as the free objective education, (888) OPTIONS and optionseducation.org. It’s great stuff.

Mr. Cott: I think this is just a start of a lot of dialogue for advisers, and they’ll continue to come to these kinds of webcasts.