By David S. Gilreath
After becoming all too accustomed to the market’s smooth ascent in 2017, many retail clients have been jolted by the return of volatility this year. Yet the resulting fear and angst present opportunities to serve clients better with options strategies that harness yo-yoing markets for additional returns.
To get clients to embrace these strategies, advisors must help them understand the underlying concepts. This is a challenging for one overarching reason: Most people’s market orientation centers around rising values, so options strategies may seem counterintuitive.
Still, clients willing to rearrange some mental furniture can get a handle on the strategies if their advisors use a well-thought-out education plan to explain benefits, risks, dynamics and nuances. In the process, they may come to see volatility as a creative opportunity for diversification and income rather than a bête noir.
Advisors who suggest options strategies to clients concerned about volatility typically encounter objections based on the perceptions that options are high-risk investments, a view fueled by publicity of over-leveraged funds and derivatives’ debacles, including those connected with the financial crisis of 2008 and those that occurred early this year. These investors may need help distinguishing these notorious situations from an ongoing meat-and-potatoes options program designed to bring in an average of a few percentage points more in income each year.
Fundamentally, accepting options strategies means understanding them as a portfolio diversifier, along with some driver’s-ed-like instruction on the prudence of limiting leverage to levels many atmospheres below what brokerages companies typically allow.
Here are some things to keep in mind when educating clients on the subject:
- Show them data illustrating the market’s long history of volatility, driving home the point that it’s a natural part of the market. Indeed, some now consider volatility to be an asset class. The message should be clear: While volatility varies, there’s no escaping it. The only course is to accept it, deal with it and exploit it while managing risk.
- Volatility options strategies are best used as a side-income producer, ancillary to returns from underlying assets, bringing limited return but with limited risk.
- To help clients grasp option-writing strategies, compare them to owning an insurance company. Clients spend a few thousand a year on insurance premiums for their homes, knowing there’s less than a 1 percent chance that they’ll file a claim. They know that over time and across their risk pools, this is how insurance companies profit. Similarly, by selling options, clients can profit over time from a consistently applied program based on sound premium-collection strategies.
- Define excessive risk with examples. The best example that many clients may remember is Long-Term Capital Management, the Nobel Prize-winning economists and renowned Wall Street traders-managed firm that fell apart in 1998 because of high-risk arbitrage trading with more than $1 trillion in global fixed-income positions. After a Fed-assisted bailout and takeover by creditors, the firm became a poster child for the perils of high leverage.
- Assigned reading helps. Give them something to read between meetings with you—rather than the scary or horrendously complex material they might find online on their own. Instead, give them a guide—either one you write yourself or one from your brokerage that you can brand with your firm’s name. The key to making these materials effective is to keep things simple, resisting the urge to inflict everything you know on readers. You can always augment this content later with in-person explanations of more complex strategies. But if you follow the path of many authors of books on this subject, trying to impress clients by going too deep into the weeds, you’ll probably be working against your interests—and your clients’. Where possible, try to work in a little humor, perhaps with colorful characterizations of hypothetical investors and their preferences. Some advisors send such a guide to clients once a year, along with a return signature form saying they received it. Thus, a guide can not only serve as helpful client education, but a helpful compliance disclosure mechanism.
By introducing the subject appropriately and then gradually filling in the blanks, advisors can inform clients of their views of volatility and position them to profit from it.
Dave Sheaff Gilreath, a 36-year veteran of the financial service industry, established Sheaff Brock Investment Advisors LLC, a retail portfolio management company based in Indianapolis, with partner Ron Brock in 2001.