By Nick Griebenow
“Iron Condors” are in the headlines these days. This esoteric, complex options trade was utilized by a large wirehouse recently with disastrous results for clients. In the fourth quarter of 2018, investor portfolios in that strategy experienced significant losses, with some accounts falling more than 20% in December alone. Inevitably, the lawsuits followed.
But advisors would be wise not to throw the options baby out with the Iron Condor bathwater. As market volatility picks up in frequency and intensity, there are ways to use options conservatively that can protect portfolios and enhance income.
Options are not inherently risky—they can actually be a vehicle for risk transfer in the stock market. There is a finite amount of risk in the market, and options are one potential way to move that risk from one party to another. For advisors to offload some of the risk in client portfolios, there needs to be a speculator who is willing to take that risk on.
The first step in determining whether a given options strategy is appropriate is analyzing the net change in market exposure from participating in the strategy. For an investor with an equity-based portfolio, implementing a neutrality strategy like an Iron Condor may not change the portfolio’s directional exposure much (or at all) when the trade is initiated.
Once the market moves, however, the directional exposure of the Iron Condor changes. In a sell-off, as the index falls the Iron Condor becomes more bullish (thus profiting or reducing losses if the market recovers). In the case of an aggressive sell-off or downturn, the equity portfolio and the Iron Condor strategy are both exposed to losses.
A popular and conservative yield enhancement strategy utilizing covered calls can increase the yield or cash flow a portfolio generates without exposing it to significant additional market risk. The strategy generates cash flows in the form of options premium without exposing the portfolio to any additional risk other than opportunity risk—having capped upside on the stock, the investor may not make as much as they would have if the call was not written (though they are still making money).
Options overlay strategies have the potential to reduce portfolio volatility, improve risk-adjusted returns and provide diversification benefits by accessing an alternative risk premium. To reduce portfolio volatility, the overlay needs to reduce the portfolio’s directional exposure. This is achieved by trading into an option position with opposite directional exposure to the underlying holding.
For example, advisors can write a covered call or buy a protective put on a client’s long stock position. Both the covered call and protective put have opposite directional exposures from the stock. This is quantitatively represented by the delta of each position (delta can be thought of as exposure to movement, a stock has a delta of 1—stock goes up $1, one share makes $1). Below is an example of a covered call on SPY:
- Buy 100 shares SPY at $284.79 (position delta = 100)
- Sell 1 SPY June $290 Call for $3.00 (position delta = (-35.7)*
- By combining the two positions above, we have a covered call on SPY with a net delta of 64.3.
- If SPY goes up by $1, our share position increases by $100 and our call position moves against us by $35.70, for a net gain of $64.30.
- If SPY goes down by $1, our share position decreases by $100 while our call position recovers $35.70 in value, for a net loss of $64.30.
Of course, there are more intricate strategies that can be employed in a conservative manner. One example would be to modify an already conservative strategy (like covered calls, protective puts) by spreading off the dominant leg of the strategy. This means selling a credit call spread rather than just a covered call.
While the income received would be less, if the underlying stock were to experience upside above and beyond the top strike price, an investor would be able to participate in that upside. On the other side of the coin, an investor could spread off a protective put and establish a debit (bearish) put spread. The debit put spread would cost less than the protective put alone, in exchange for covering only a certain range of the stock’s potential downside.
Bottom line, advisors and their clients should be sure to understand how an options strategy will work with their portfolio and be willing to at least consider them. While they may not be a perfect fit for all, the potential advantages some options strategies provide are at least worth the time to review them.
*The delta on a call is positive, but selling positive delta causes the position to have negative delta in the portfolio (-1 contracts * positive delta = (-delta) to the seller)
Nick Griebenow is an assistant portfolio manager at Shelton Capital Management.