Rising Volatility: Generating Income with the use of options
With the rise of market volatility, the Cboe Volatility Index climbed as high as 22.96 this Wednesday (10th Oct 2018), we would like to discuss how a portfolio with options strategies can achieve yield enhancement, especially in times of rising interest rates and growing turbulence in the equity markets.
Most investors typically look at historical volatility as a guide to the future. This, however, can lead to a false belief of security. The more favourable the markets, the less likely the volatility will rise. In fact, the opposite is true.
Institutional and retail investors have traditionally used options for risk management purposes. On the other hand, investors have started to use options for yield enhancement, which provide an alternative source of return to their portfolios.
This piece provides the background and examples on two of the most common investment strategies amongst Pinerion’s Managed Volatility Portfolio:
i. Call overwriting
ii. Put overwriting
For each strategy, we discuss the investment rationale, with the potential benefits and risks of the associated options writing strategy.
Call overwriting is one of the most widely used options-based strategies amongst institutional investors. It involves selling a call option (the right to buy the stock by a certain date at a certain price) on a stock that an investor currently owns where the strike price of the call option is usually higher than the current price of the stock (i.e., out of the money). The combined position is often referred to as a covered call. The following chart compares the hypothetical profit and loss of a covered call position versus a long position in the stock on the option expiration date. It assumes a strike price of $120, current stock price of $100 and a call option premium of $10.
In a covered call position, the long stock position “covers” the selling of the call option if there is a sharp rise in the underlying stock price. In other words, an investor would have limited upside exposure to a stock in exchange for a premium from selling the call option. Therefore, such strategy aims to reduce the risk of a long stock position because the premium from selling the call option can offset losses from a decrease in the stock price. The primary risk with call overwriting is the portfolio could significantly underperform in a bull market such as in 2017.
At Pinerion, we use call overwriting strategy to generate additional income for the Managed Volatility Portfolio. Our strategy, however, does not hold the underlying stock / index when we sell the call options. Therefore, we would identify the best terms (i.e. underlying structure, strike price and expiry) when we write the call options, and we will monitor the volatility and other risk parameters throughout the life of the options. If there is a change in market conditions, we can choose to hedge or monetise our options positions to achieve the best risk/return profile.
While call overwriting strategy is the most prevalent strategy amongst institutional investors, put overwriting is widely used amongst private banking investors. Put overwriting involves selling a put option (the right to sell the stock by a certain date at a certain price) in order to synthetically gain long exposure to the underlying stock. A short put position is similar to being long a stock, because both positions are profitable if the stock price rises and vice versa. As such, the main risk to the strategy is if the price of the underlying stock falls, but unlike with the long stock position, the premium from selling the put option can offset some of the loss. The following chart illustrates the hypothetical payout profile of a short put position versus a long stock position. It assumes that the underlying stock price is $100, a strike of $90 and the option premium of $10.
More and more investors are beginning to understand the potential benefits of including options strategies in their portfolio. They see the value that can be added by not only using options for risk mitigation, but also for yield enhancement. This piece outlines two of the most commonly used options strategies: call overwriting, put overwriting. We will discuss other option strategies in our future issues.
At Pinerion, we seek to offer an alternative means of returns with the use of options strategies, while uncorrelated to traditional asset classes and safeguarding clients’ assets in periods of financial market turmoil.