Enhancing Equity Portfolios Through Option Overlays

Apr 29 2015 | 6:39am ET

By Arnold DiLaura
Managing Director, AUA Capital Management

Writing covered calls on equity positions in a portfolio is a useful way of generating additional income as the call writer is monetizing a portion of the stock’s potential upside over the option’s 30- or 60-day lifetime.

The risk of covered calls is that at expiry the stock will be higher than the strike price and either the stock will be called away, the short call will have to be bought back, or the option position will be “rolled”– the short call will be bought back and the purchase will be financed by selling a longer-dated, higher-strike price call. Rolling in effect gives the stock further room to appreciate.  If a stock is called away, another potential strategy is the use of a cash-secured put which we discuss in more detail below.

When looking at a portfolio, there are two ways to write calls: 1) The first is on a portion of some or all of the individual stocks in the underlying portfolio, 2) The second is to write index call options on the portfolio as a whole.  Each technique has its own advantages and disadvantages.

Writing calls on the individual stocks will generate more income, all else being equal. This is because the implied volatility of options on individual stocks is almost always higher than the implied volatility on an index which includes the underlying stocks. All else being equal, the higher the implied volatility, the higher the option premium. Figure 1 below shows a comparison of the annualized stand-still returns at various call-away probabilities for an ETF which trades at a 20% implied volatility versus a 38% implied volatility.

click to enlargeclick to enlarge
 

Even though writing calls on the index generates less income, it has certain advantages: 1) The first is simplicity, in that the call writer is writing options on one index, not 30 or 40 stocks, 2) The other advantage is that the individual stocks are free to appreciate unencumbered. If one of the stocks in the portfolio is the subject of a takeover and doubles overnight, the stockholder gets the full gain.  If options had been written on the stock, the stockholder would only get the gains up to the strike price.

Figure 2 shows a graphic comparison between writing calls on individual stocks in an illustrative large-cap portfolio, and writing an index call on the same portfolio. In this example, the portfolio is equal capital weighted. In selecting options for individual stocks, one can first calculate the probability that any particular strike price will be in- or out-of-the-money at expiry. One can then look for those options that have a 25% probability or less of being in-the-money (ITM), and that still generate a sufficient annualized return. The specific stocks, option strike prices, premiums, percentages out-of-the-money (OTM), and stand-still returns are shown in Table 1.  Writing a call on each stock will generate about 80 b.p. in premium (relative to the total value of the equity portfolio) over the 60 day period, or an approximate 4.8% annualized return. Table 1 shows that the option strike prices vary from about 3.5% to over 9% OTM. This means that the stocks can appreciate from 3.5% to 9% over a 60 day period without the risk of being called away.

For comparison purposes we selected and sized an index option on the portfolio as a whole which would generate the same amount of option premium, 80 b.p.  As Figure 2 shows, the index strike price is much closer to at-the-money (ATM) than any of the single stocks – about 2%.  This means that the risk of underperformance in a rising market is significantly higher with the index option methodology than the single stock option methodology – 2% vs. 5%.

click to enlargeclick to enlarge

Chart 1

Ticker

Last

Strike

%OTM

Stand-still
Return
(Annualized)

EMC

26.28

28

6.54%

3.31%

SNY

52.56

55

4.64%

5.99%

CAH

66.2

70

5.74%

3.85%

AAPL

604.71

640

5.84%

6.00%

NOV

82.07

85

3.57%

6.18%

ORCL

41.56

45

8.28%

3.46%

MSFT

39.68

42

5.85%

3.63%

USB

41.11

43

4.60%

3.28%

ECL

106.67

110

3.12%

5.20%

TMO

114.47

120

4.83%

8.12%

XLK

36.71

39

6.24%

0.74%

TWX

68.8925

75

8.87%

3.00%

JCI

46.68

50

7.11%

5.14%

COP

77.85

80

2.76%

6.20%

CELG

147.65

160

8.36%

8.07%

MON

115.9

120

3.54%

9.01%

GOOGL

540.39

560

3.63%

12.60%

PFE

29.25

31

5.98%

5.33%

STJ

64.13

70

9.15%

6.08%

SPY

187.55

195

3.97%

1.23%

WFC

48.96

52.5

7.23%

1.84%

QCOM

79.86

85

6.44%

1.62%

BA

129.58

135

4.18%

6.76%

JNJ

100.25

105

4.74%

1.83%

PEP

85.65

90

5.08%

2.38%

XOM

100.67

105

4.30%

3.40%

WAG

68.88

75

8.89%

6.45%

BBT

37.09

39

5.15%

4.37%

UTX

113.1

120

6.10%

2.31%

DIS

81.09

85

4.82%

6.33%

PG

80.23

85

5.95%

1.12%

EWBC

32.95

35

6.22%

9.10%


What about Puts?

Until now we have been talking about using covered calls to generate income on an equity portfolio.  Put options, which convey the right to sell a particular stock at a particular price at some point in the future can also be used as part of an options overlay strategy.

One way they can be used is for protection: one can use a portion of the cash premium generated by selling covered calls on individual stocks to purchase broad-based ETF or Index puts (or put-spreads) thus providing a degree of  downside protection for the portfolio as a whole.

The second use of puts in an overlay strategy consists of selling cash-secured, out-of-the-money (OTM) puts as a way of potentially acquiring a stock cheaper than its current price. For example, let’s say we like XYZ stock at its current price of $50, but we would like it even more if we could get it for $45. We could sell a 60-day, $45 strike put for $1. If the stock declined to $45 or below at expiry, we would then be obliged to buy the stock at $45. But we would have still taken in the original $1 credit, which is a stand-still annualized return of 13%.

This strategy can also be used for stocks which have been called away. For example, if one wrote an 80 strike call on a stock that had been trading in the 70s but which subsequently shot up over 80, that stock would be called away.  However, after the stock was called away one would have $80 in cash, and assuming one still liked the stock, they could write an 80, or even 75, strike put, taking in an additional cash premium while waiting for the stock to decline to where they would buy it again.

Overlay Timing

When are the best times to implement options overlays?

1) Anytime an investor or portfolio manager needs to generate more cash than will be provided by the regular interest and dividends from portfolio assets. Selling covered calls can avoid the need to liquidate assets to cover disbursements.

2) When equity valuations are stretched and consequently huge gains going forward are less likely. In this environment, where long term equity returns are projected to be in the low single digits, a covered call program could double or triple those returns.

AUA Capital Management is an independent asset manager and advisor focused on providing active, portfolio and asset management services for private clients, institutions and enterprising families. At AUA we combine our core equity and fixed income exposures with opportunistic alpha investments, as well as risk moderating assets, to provide our clients’ with customized full portfolio management solutions.


In Depth

PAAMCO: Will Inflation Deflate the Asset Bubble?

Jan 30 2018 | 9:49pm ET

As the U.S. shifts from monetary stimulus to fiscal stimulus, market pricing should...

Lifestyle

CFA Institute To Add Computer Science To Exam Curriculum

May 24 2017 | 9:25pm ET

Starting in 2019, financial industry executives sitting for the coveted Chartered...

Guest Contributor

Boost Hedge Fund Marketing ROI By Raising Your ROO

Feb 14 2018 | 9:57pm ET

Tasked with delivering returns on client capital, a common dilemma for many alternative...