Swiss Army Knife of Option Overlays
Guest Author: Shawn Gibson, Co-Founder, Liquid Strategies
The term “Option Overlay” has become trendy as more advisors and asset managers have discovered the power and appeal that option strategies can have in a portfolio if structured and managed properly. The team at Liquid Strategies (Advisor to the Overlay Shares suite of ETFs) recognized this over 10 years ago and have been running overlays in separate accounts and funds ever since. The keys to the successful implementations of overlays are 1) selecting the right overlay for the portfolio need or desired outcome and 2) properly managing risk in the structure to lessen the chance of a poor outcome.
What is an Option Overlay?
An Option Overlay is an options structure that is added to an existing portfolio (it “overlays” the portfolio) to control or change the potential outcomes of the underlying portfolio. A key benefit of overlays is that a portfolio’s risk/reward profile can be changed without having to change the asset allocation of the underlying portfolio, thus avoiding any potential tax implications of selling holdings that may have significant gains.
An overlay can consist of a single option position, such as a covered call, or can include a large number of puts and/or calls held long and/or short. The only limitation to the potential outcomes that can be created with an overlay is the creativity of the team creating the structures. Generally speaking, there are 3 main outcomes that investors are looking for when selecting a potential overlay for a portfolio:
- Yield Enhancement – increase the cash flow on a large single position or on a portion of a total portfolio
- Risk Management – decrease the downside risk in a large single position or reduce risk and volatility in a diversified portfolio
- Growth Acceleration – help a portfolio potentially get higher total returns
One Overlay that Can Help Achieve Any of 3 Outcomes
The team at Liquid Strategies specializes in managing an overlay that is designed to generate positive incremental cash flow on top of an existing portfolio. With this approach, an investor still retains all of the benefits and risk of the underlying portfolio without capping any of the holdings, while adding in the potential cash flow and risk of the overlay program. This is done by selling short-term below-market put spreads on the S&P 500 Index (“SPX®”).
As an example, similar to the approach used by Liquid Strategies, selling 2-week put spreads on the SPX with the short put strike at 98% of the SPX and the long put struck at 95% of the SPX, an investor would have experienced the following returns and risk over the past 15 years:
Source: ORATS and Liquid Strategies, LLC. Based on selling 2-week 98/95 put spreads on the S&P 500 Index
Over the 15-year period, this program generated a positive return of 1.89% on a standalone basis, meaning this strategy applied as an overlay against an existing portfolio would have increased the portfolio’s total return by the amount of that excess return. The following sections detail how this return can be applied to help an investor achieve better outcomes.
The return generated by this overlay can simply be pulled from the portfolio as income. This could provide a significant yield enhancement for an investor. For example, if an existing portfolio is currently yielding 4%, this serves a nearly 50% increase in yield. Importantly, this yield potential from a dollar basis grows as the underlying portfolio grows. An extra 1.89% on a $1.5 million portfolio provides significantly more cash than a $1,000,000 portfolio ($28,350 vs. $18,900).
An interesting use for this income could be debt repayment. For example, using this 1.89% yield to offset interest expense of a $1,000,000 7.50% loan could reduce the net interest expense by over $180,000 during the life of the loan.
Source: Liquid Strategies, LLC
Another possibility for this same loan would be to apply the cash flow towards principal repayment which would have the loan paid off 44 months sooner.
Some investors may be uncomfortable with the overall risk in the market or may have specific areas of concern (such as a concentrated stock position). These investors can use this incremental yield to buy downside protection. The following shows two examples of what the overlay could pay for against 1) a diversified large cap equity portfolio, and 2) a concentrated stock position in Apple (AAPL).
Source: LiveVol. Based on midpoint of closing prices on 11/10/23. The hedge for Investor 1 is based on SPX options and AAPL options for Investor 2
With a 1.89% overlay return, Investor 1 could finance a 1-year 95/83 “buffer”, meaning at expiration they are at risk for the first 5% down and then at risk for anything below 83% of the initial value. They are fully protected at expiration on the losses between -5% and -17% in the SPX. For Investor 2, they could buy an outright long put out 13 months that protects them against any decline in AAPL of more than 25% at expiration.
There are a wide variety of combinations of expiration dates and strike prices that can be used to customize this hedging structure.
Finally, some investors may simply want to grow their portfolio more quickly and can potentially do so by reinvesting the return from the overlay to enjoy the benefits of long-term compounding. Over a 15-year time period from 10/31/2008 to 10/31/2023, $1,000,000 invested in the S&P Index on a total return basis (dividends included) would have grown to $5,770,917 while adding the overlay to the same portfolio would have finished at $7,165,167. This is an increase in wealth of almost $1.4 million, a 24% increase of simply being in the market without the overlay.
Source: Liquid Strategies, LLC
What Can Go Wrong
As with all overlays, every variety comes with risk. Most overlays utilize call writing as a key component. While certain market environments and certain situations may be more optimal for call writing, the primary risk for call writing is the opportunity cost of the underlying position or index finishing significantly higher than the strike prices written. The likelihood of an investor incurring this opportunity cost over the long term is high as a) markets and stocks tend to rise over the long term, and b) the volatility risk premium of above-market calls tends to be much lower than that of below-market puts which reduces the margin for error in writing calls.
This overlay approach adds a defined amount of downside risk at all times. In this case it is 3% (the spread width) minus the premium collected. For example, if the premium collected is 0.50% then the total risk for that position is 2.50%. Over time, there can be multiple falls in the market at various times that could result in multiple losses. The idea is that over the long term, more premium will be collected from successful positions than paid out for unsuccessful positions. In the case of the approach highlighted, that net premium difference resulted in an annualized return of 1.89%.
The key consideration is that losses in this approach tend to happen when there is stress in the market, which could result in temporarily increasing the losses in an investor’s portfolio. This overlay approach, while only having annual standard deviation of 3.51%, experienced a maximum drawdown of 7.64%. So, investors need to be prepared that drawdowns will happen, but these drawdowns are necessary to allow this opportunity to stay intact. If the market never fell, no one would want to pay any attractive amount for downside protection!
About Overlay Shares
The Overlay Shares suite of ETFs are managed by Liquid Strategies, LLC which has been running Option Overlays since 2013. In addition to managing overlays within the funds, the firm works with advisors to help structure and manage customized turn-key overlay SMA programs.
About the Author
Shawn co-Founded Liquid Strategies in 2013 and serves Chief Investment Officer and is a member of the firm’s Executive Management Committee. Shawn brings more than 25 years of investment experience primarily in the area of options trading and options portfolio management. Shawn started trading options in 1997 as a market maker on the floor of the Pacific Exchange. He subsequently served as Head of Options Strategy and Director of Alternative Investments at BB&T, where he worked with advisors and their clients to develop options-based hedging and yield enhancing strategies.
Shawn is an active member of his community and was voted as one of the Top 40 leaders under 40 while living in Richmond after being nominated by his peers due to his professional accomplishments and community involvement. Shawn earned his B.S. in Commerce from the University of Virginia.
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