Insight post

Nov. 23, 2018

Options-Based Income Strategies

Understanding the Diversity of Options Strategies

Know What You Own Series

While Morningstar’s addition of the Options-Based Fund category is welcomed, it would benefit from further division into distinct subcategories. We would classify these subcategories as,

  1. Hedging Strategies
  2. Income strategies
  3. Alpha/trading strategies

Our last post covered hedging strategies, so now we turn to income strategies, their primary objectives, variations, when they work, and their risks.

Options-Based Income Strategies

Like hedging strategies, income strategies typically have traditional, long holdings at the core of their portfolio. However, such strategies seek to supplement the returns of their portfolio by trading options. These trades typically involve the writing of short-term calls and/or puts. The compensation or “premiums” collected from this option writing can be an additional income stream to the return of the core holdings.

Variations within the Category

There are a few different types of approaches managers can take to generate income. Covered call strategies are one approach, and they typically hold a portfolio of equities and write calls on the portfolio. Another approach is with put-write strategies that typically hold cash or fixed income securities and write puts using cash as collateral. There are other trades that can generate income with varying levels of return and risk, but these two strategies are the most popular.

It is important to remember that income strategies do not explicitly hedge the market. While they might have lower overall risk and can help diversify a portfolio, by definition the purpose isn’t to mitigate downside risk but to generate income.

When It Works

Income strategies typically work best in a gently rising market. A covered call strategy does well if the value of the long portfolio edges upward, but not so much that the short calls go in the money and further gains are called away. A put write strategy does well if markets go up, since the cash position will earn interest and the written puts expire worthless, leaving the writer with all of the premium. In calm markets, income-based strategies can make a lot of sense.

Possible Risks and Drawbacks

If income strategies do well in calm markets, it stands to reason that they will do poorly if markets make a big move, either up or down.

Opportunity Cost

If markets are trending strongly upwards, a covered call strategy could see a good portion of its market gains disappear. If a call is written, say, 2% out of the money and the market goes up 6%, the strategy will not enjoy the full upward move in the market. The gains to the strategy will be capped. The strategy essentially sold off the unknown potential for gains for the known gain of the option premium. This should be viewed as an opportunity cost.

Inability to Hedge Large Drawdowns

But the bigger risk to most income strategies happens when markets sell off. A covered call strategy consists of two parts: a traditional long position and some short calls. If markets sell off significantly, the premium collection from the short calls might offset a bit of the downward move in the long portfolio. However, in the face of a significant sell off the long portfolio is unhedged and premium from selling calls is unlikely to fully offset losses.

A put-write strategy has a similar risk-return profile. The cash position will help insulate against a market sell-off, but the short puts expose the strategy to losses the more the market goes down.

Leverage

Finally, one of the biggest risks to any strategy that writes options is leverage. If a strategy opts to write two, three, four, or more options against their collateral positions, the potential for losses can accelerate quickly. Many of the well-publicized blow-ups in derivative strategies can be blamed on leverage more than anything else.

Every Strategy Has a Purpose/Objective

Options-based strategies can be quite different from each other. This is why it’s important to be able to differentiate between them. One of the more important steps is to figure out what the strategy’s main objective is and see if it aligns with what you’re looking for in an options strategy, whether it’s hedging, income, or alpha.

With that in mind, delve into how it accomplishes its objective and compare risks among strategies and determine which one is best suited for each of your clients.

In the next post, I discuss the last of the three subcategories: alpha/trading strategies.

About the Author:

Marc OdoCFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly, Marc was the Director of Research for 11 years at Zephyr Associates.

Important Notes and Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®).

All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970–382-8901 or www.www.swanglobalinvestments.com463-SGI-111518