How to Improve Risk/Reward Profiles by Aligning Options Strategies to Portfolio Rebalancing Rules

Guest Author
January 11, 2023

Cboe Guest Author: Joe Cusick, Calamos Investments

The goal of rebalancing a portfolio is to drive excess returns with lower risk. Savvy retail investors, high net worth participants, professional advisors and large institutions, such as pensions, endowments and foundations, have long implemented rebalancing strategies using options. Many investors are unfamiliar with this approach but quickly learn how simple it can be to implement an options strategy within their current risk management structure.

Annualized Excess Returns by Vol Regimes Over the Business Cycle

Source: Cboe Global Markets, Federal Reserve Bank of St. Louis, Yahoo Finance

When an investor rebalances with options, they ares applying a portfolio's existing rebalancing rules using options strategies to improve investment risk-adjusted returns. Many institutional portfolios have a formal written rebalancing policy to specify a procedure to maintain the portfolio's asset allocation within certain target limits. The return improvement varies depending on the portfolio's exact rebalancing rules but usually falls in the range of 8-10 bps. Over time, a $5 billion portfolio could add $4 to $5 million per year to gross returns using a successful rebalancing strategy with options.

Performance and Risk Measures Over the Period May 1990 to March 2015

Source: Cboe Global Markets, Federal Reserve Bank of St. Louis, Yahoo Finance

(Past performance is no guarantee of future results. Results are before taxes on fund distributions and assume reinvestment of dividends and capital gains.)

Let’s examine rebalancing in a hypothetical portfolio with asset allocation that targets 60% stocks and 40% bonds. It’s common to have specific rules to rebalance assets back to their target. For instance, if stocks increase in value such that the portfolio has 63% stocks and 37% bonds, the investor would sell 3% in stocks and buy 3% in bonds to rebalance back to the target of 60% stocks and 40% bonds. Similarly, if stocks fell to 57% of the portfolio's value, the rule dictates selling bonds and buying shares to rebalance back to 60/40.

A rebalance rule helps maintain a target level of portfolio risk. Generally, the more significant the portion of the portfolio in stocks, the higher the expected return. However, a higher allocation to stocks also increases the portfolio's risk. 

In essence, rebalancing is a disciplined way of implementing a "buy low" and "sell high" philosophy—without the emotional baggage. Having predefined rebalance rules prevents behavioral biases from disrupting a disciplined portfolio management process. Typically, it is to an investor’s advantage to buy stocks in a market downturn when stock prices have declined and the risk of owning stocks feels greatest. However, it can be almost impossible to have an investment committee initiate the discussion to purchase shares and approve the decision during a financial crisis. It's far better to establish a rebalance policy in advance based on rational investment techniques.

Cash-secured Short Puts & Covered Calls in Rebalancing

Stock owners have several rights. One is the right to sell stock at the market price. Covered call writing is merely selling this right for a period of time, via a call option contract, to someone else in exchange for cash paid today. The call option seller gives the buyer of the option the right (but not the obligation) to buy shares at a predetermined price called the strike price. The stock owner (call seller) receives money (premium) for selling this right.

If the call option seller owns the underlying shares, the option is considered covered. If the price of the underlying stock rises and the option buyer exercises it, the seller won't be forced to purchase shares at a potentially high market price; the option seller can deliver the shares they already own. Because the call sold is covered by the underlying shares owned, the strategy has relatively low risk. Covered calls are a familiar strategy for institutional investors but most brokers allow using the covered call strategy in an individual retirement account, as well. 

Source: Calamos Investments, LLC

The chart above compares the profit/loss of owning a stock and a covered call position.The covered call position, the blue line, provides a higher profit than simply holding the stock, except when the stock price increases beyond the strike price before the expiration. The investor would be worse off if the underlying stock increased by more than the income generated by the sale of the call option contract. 

A simple description of the rebalancing using options strategy can be made with an analogy to the covered call strategy. Let’s go back to 60/40 portfolio example. Imagine selling calls on the stocks' benchmark every month at the strike price where the portfolio would have 63% in stocks. If shares rise such that the portfolio has 63% stocks and 37% bonds, 3% of the stocks will be delivered to the option buyer when the option is exercised. Selling puts at the stock price where stocks would have fallen to 57% of the total portfolio's value will similarly force the purchase of stock, just as the rebalance rule would require.

Options: Insurance for Investors

Option writers are like insurance underwriters. For example, if you own a stock with a market price of $148 and want to ensure you cannot lose more than 5%, you can buy a 135-strike put option. This is analogous to buying a car insurance policy with a 5% deductible.

Source: Calamos Investments, LLC

The seller of the 135 strike put in this example is acting as an insurance underwriter. Options are usually priced to provide the underwriter with an insurance-like profit margin. In the world of options trading, this equates to "realized volatility is generally less than an option’s implied volatility."

Most option market participants do not have a fundamental need to sell if the market rises or to buy if the market falls. Portfolios with rebalancing rules do have this need to buy and sell; therefore, there is a unique synergy between the rebalancing rules and the requirements of an option seller.

When a portfolio rebalancing with options sells the 135 puts, it aims to buy the underlying security when it falls to a price of $135.

Rebalancing Rules and Options Synergy

Rebalance rules require buying stocks when stock prices decline to the rebalance trigger price and selling stocks when stock prices increase to the rebalance trigger price. Selling out-of-the-money calls and puts also requires buying stocks when stock prices decline to the put strike price and selling stocks when stock prices increase to the call strike price. Aligning the strikes of options sold with the portfolio's rebalance points creates a synergy that could generate additional investment income, with an attractive risk/reward tradeoff.

Performance and Risk Measures Over the Period May 1990 to March 2015

Source: Cboe Global Markets, Federal Reserve Bank of St. Louis, Yahoo Finance

(Past performance is no guarantee of future results. Results are before taxes on fund distributions and assume reinvestment of dividends and capital gains.)

Historically, this strategy has typically added roughly 8-10 bps per year to total gross portfolio investment returns. Variations on this strategy and implementation by a skilled manager could provide an additional return.

This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email [email protected] or contact your Cboe representative to learn more.

Contact Joe Cusick at [email protected] with any questions directly.

There are important risks associated with transacting in any of the Cboe Company products or any of the digital assets discussed here. Before engaging in any transactions in those products or digital assets, it is important for market participants to carefully review the disclosures and disclaimers contained at: The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Global Markets, Inc. or any of its affiliates.

Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The views and strategies described may not be appropriate for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned and, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.

Options Risk. Options strategies entail risk. An investor’s ability to close out a position as a purchaser or seller of an over the counter or exchange-listed put or call option is dependent, in part, upon the liquidity of the option market. There are significant differences between securities and options markets that could result in an imperfect correlation among these markets, causing a given transaction not to achieve its objective.

An investor’s ability to utilize options successfully will depend on the ability of the investor to predict pertinent market movements, which cannot be assured.

Indexes are unmanaged, do not include fees or expenses and are not available for direct investment. The S&P 500 Index is considered generally representative of US large cap stocks. Cboe S&P 500 5% Put Protection Index (PPUT) is a benchmark index designed to track the performance of a hypothetical risk-management strategy that consists of a long position indexed to the S&P 500 Index (SPX & Index) and a long position in the monthly 5% Out-of-the-Money (OTM) SPX Put options. VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.