Are Option Overlays a Must?
Coffee With Cott is a blog from The Options Industry Council's Financial Advisor Division. Eric Cott, the author, is a former advisor who has been the Director of Financial Advisor Education at the OIC since he developed the organization's outreach program in 2009. Coffee With Cott offers percolating insight on options strategies, as well as practice management ideas.
Many investors – large, small and every account size in between – wonder at some point if the best they can do is keep pace with the market's ups and downs. Should you just go the passive route? Or should you be active? It's not a quick decision like deciding whether to take your coffee mild, medium or strong – trying to be better than the market usually involves taking on more risk, meaning you potentially have to deal with jolts.
Let's face it: If brewing up an amazing investment plan and beating the market was easy, everybody would do it. Of course, we all know it's not easy. And no method is guaranteed to outperform on the upside and produce smaller declines on the downside.
However, there may be something to consider by way of the options market if your clients in fact do want to pursue outperformance, and it's called the option overlay. Overlays are fairly common in the options world, but when you're new to them, it may seem like one of those things that's better left to somebody else. It's true that overlays are never going to be a plain cup of joe, but if you take a closer look, you might find they don't seem like the world's most complicated cappuccino, either.
As always, we at OIC have to stress that options have risk, and they're not going to be right for every investor or every situation. But we also believe they can have their place. My goal is to get all you advisors out there thinking about how to talk to clients about what options can do and how they could possibly enhance your practice.
So, let's get a quick definition of overlays. An overlay is a strategy that's used when an investor owns a position, say a stock or ETF, and they add an option sale or purchase on top of it. There could be a few reasons for overlays, but generating income is probably one of the most common motivations, though you could also consider an overlay for providing protection or an exit price.
One of the main strategies for incorporating overlays is the covered call. With a covered call, an investor owns 100 shares of a stock or ETF and sells a call against it. If the stock is bought and the call is sold at the same time, this is usually referred to as a buy-write.
The call sale generates immediate premium income, but it opens up the possibility the account will have to deliver the stock if it rises above the strike price. That may be fine if the investor is prepared to sell their holdings, although if they want to mitigate that risk, they could choose a farther-away strike. Either way, the investor gets to the keep the income from the call sale. (Learn more with OIC's video on covered calls.)
Another overlay idea involves selling puts. It's possible you've heard about selling puts, and you think this is just too risky for your clients. Well, you know your clients best – however, based on a study commissioned by OIC in 2017, many advisors have considered this strategy. So, let's fill up the mug and provide some flavor as to why this could be a beneficial idea.
There's one particular strategy called the cash-secured put, and it works like this, although it's important to note that not every firm allows these trades. Assuming your firm does, your client would sell a put for income and simultaneously set aside enough money, either in cash, a Treasury or some other liquid security, so that they can buy the underlying stock or ETF if it drops below the strike price and they get assigned. In this situation, they've received upfront income, and the money is set aside to buy the underlying if required. If they do get assigned, they would own the underlying. But this is how options can provide options: Your client may then turn around and sell a call for another income-generator, plus set an exit price.
We recently talked to Fariba Ronnasi, a member of the OIC advisor leadership council and founder of Elite Wealth Management in Kirkland, Wash., about this very strategy for an article that appeared in ETF.com.
Let us mention another idea. It's known as a put spread collar, and it was featured, along with the covered call, in a recent study on overlays that was commissioned by OIC, called Endowment Risk Management and Return Enhancement with Listed Index and ETF Options. The study looked at how covered calls (the buy-write) or put spread collars could improve performance for endowments.
A put spread collar admittedly is a more complex blend than some overlays. With this particular collar, the investor sells a call and deploys a bear put spread at the same time. The bear put spread is two positions – a long put and a short put with the same expiration, but the short put has a lower strike. A standard collar is a covered call plus a long put, and is sometimes referred to as a hedge wrapper. The put spread collar adds a short put, the sale of which offsets some of the cost of buying the long put. While the other strategies I discussed are more for income, this collar is usually a risk management tool. A collar limits your upside, but it also adds a protective floor.
With option overlays, you may be looking at an opportunity to help clients enhance their holdings. Again, every situation is unique, but overlays may be worth reviewing. What's also notable about overlays is that they can be done by all kinds of investors, with all sizes of accounts. Retail investors can do it, and so can institutions like endowments. Are overlays right all the time? No strategy is one-size-fits-all, but when the client's goals and risk appetite align with what overlays can provide, it's a strategy to consider.
If you want to get more percolating ideas about overlays and other strategies, you can visit the website of The Options Industry Council. OIC is a resource for advisors like you, and we're here to assist you in your understanding of options and how they might benefit your clients and your practice. But we are just as determined to make sure you understand the risks. Also, you're always welcome to either email me directly at email@example.com or write the Investor Services team at firstname.lastname@example.org.
Finally, be sure to watch for our next Coffee With Cott blog: Option Strategies That Can Protect Capital Gains. Do you have a topic you want to see covered in the Coffee With Cott blog? Let us know by writing to email@example.com.
Options involve risk and are not suitable for all investors. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org.
Any strategies discussed are strictly for illustrative and educational purposes and should not be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. ©2019 The Options Industry Council. All rights reserved.