Today’s investment advisors tend to use exchange-traded funds, or ETFs, and mutual funds in allocated portfolios. That’s quite different from the individual stocks that your grandparents’ broker relied on, but some advisors still find ways to hedge against downside risk and enhance portfolio returns.
“I use options to lower the overall risk of just owning long stock or index ETFs, and at times add additional yield/income through selling covered call options,” says Scott Elisha, lead option strategist and wealth advisor at Perigon in San Francisco.
Here are some strategies that advisors use with options, as well as methods for avoiding excessive risk:
— How advisors can use options in client portfolios.
— Strategies advisors can deploy for options in today’s market.
— How advisors can avoid excessive risk with options.
How Advisors Can Use Options in Client Portfolios
Elisha currently uses options in three ways:
— A model-based covered call selling strategy.
— Cash secured put-writing (or selling), which allows him to buy stocks or ETFs at below current market prices if they go below the strike price where he sold them. This strategy involves writing a put option while also maintaining enough cash to buy the underlying stock. This potentially allows an investor to buy the stock below its current market price.
— Zero-cost collars, which entails purchasing proactive put options to protect a position and selling upside call options with the same cost as the put. That’s what makes it “zero cost.”
Elisha believes options are beneficial and useful in all market situations. However, given the sustained high levels of volatility in today’s market and elevated levels in the Chicago Board Options Exchange’s CBOE Volatility Index, he says it’s a good year to utilize call selling and cash-secured put writing.
Strategies Advisors Can Deploy for Options in Today’s Market
Stephen Akin, founder and investment advisor representative at Akin Investments in Biloxi, Mississippi, has used options for many years, sometimes with a very simple strategy of put or call purchases on the direction of an underlying stock or overall market.
“When you hold a nice dividend-paying company, you can enhance the total return by doing a covered call writing strategy,” he says.
“Another easy way to buy a stock in volatile markets is to sell a put on a company that I’d like to buy,” Akin adds. “If the stock weakens enough to have the option exercised, I’m in at a lower price. If it’s not exercised, simply book the profit on the expired put. This also enhances total return on the portfolio.”
He also uses options as a hedge on holdings as a form of portfolio insurance. This strategy can even be adapted for fixed-income holdings.
“Options, when understood and used prudently, are a wonderful tool,” he says. “Unfortunately, we hear all too often about option-market disasters. That comes from traders who simply don’t understand the products and risks that they may carry.”
Laurie Itkin, financial advisor at Coastwise Capital Group in La Jolla, California, says her firm often writes covered calls for clients who need to withdraw funds on a periodic basis. She also uses covered calls on dividend-paying stocks as well as certain growth stocks that can generate significant call option premium.
“Using covered calls allows clients to access three potential profit sources: Capital appreciation, dividend income, and call option premium,” she says.
“The covered call strategy will likely underperform in a bull market, but clients understand that they are giving up potential upside in exchange for consistent income and a little bit of downside protection,” Itkin adds.
In some cases her firm also writes cash-secured put options.
“Managing a portfolio with an options overlay takes more time and skill than managing an ETF or mutual fund portfolio, and management fees often reflect that,” she says, adding that these accounts tend to be customized.
Robert Drach, founder at Drach Advisors in Blue Hill, Maine, uses simple put and call strategies in select client accounts to generate income. He notes that he only uses options if they are aligned with the firm’s underlying investment strategies.
“Most of our assets are dedicated to strategies that buy high-quality stocks that are out of favor, and then sell them at strictly determined exit points,” Drach says.
How Advisors Can Avoid Excessive Risk With Options
To avoid taking on excessive risk, Drach follows fairly simple strategies selling covered calls and cash-secured puts.
“If we have accumulated cash in client accounts, we look for high-quality stocks we would be happy to own at lower prices, then sell out of the money cash-secured puts, with strike prices at or below prices that we would typically be buyers,” he explains.
When the firm is long equities in client accounts, Drach will sell covered call options with strike prices at or above his price targets.
He also uses other options strategies, such as buying puts, to hedge risk.
He notes that “naked” puts and calls are essentially highly leveraged tools to make strong-conviction bets, which can be risky.
To avoid significant one-sided risks, many traders hedge their positions with other options contracts, Drach notes, adding that “these strategies can get complicated quickly, and with large bid/ask spreads in many options, these strategies can also become costly, quickly eroding potential gains.”
He points out that markets are far less liquid than equity markets, and taking a position that you are not comfortable holding can be very costly to unwind.
“Because of the risks and complexities, we prefer to keep things very simple and make sure they align with our underlying strategies,” Drach says.
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Advisors Turn to Options to Protect Capital and Even Boost Returns originally appeared on usnews.com