Investment Advisors using Options

Over the years, no topic has been more controversial then the use of options by investment advisors for unsophisticated clients. This has now reached levels where a number of Canadian wealth management firms have placed compliance restrictions on advisors, limiting them to using only the simplest strategies for their clients. Understandably, there have been advisors that have misused options and potentially exposed their firms to unnecessary liabilities; however, this mistakenly overshadows many unique benefits the options can offer the client.

Advisors today focus more and more on attracting high net worth clients. The problem is that it is becoming increasingly competitive to attract and close those clients. Many advisors seek to demonstrate strategies that create alpha (more attractive risk adjusted returns). The difficulty of today’s financial world is that the asset classes of cash and bonds have little to no yield, with a real risk of decline during any period of rising interest rates. This has many managers seeking creative solutions of enhancing returns without compromising the benefits of diversification.

Options to Manage Systemic Risk

Let’s debate the idea of allocating a percentage of a client’s assets to an index ETF with an options collar associated with it.

Let’s assume that the advisor is managing a client with $4,000,000 in assets. The advisor decides to allocate 10% of the clients assets to the iShares S&P/TSX 60 Index Fund (TSX:XIU). The advisor buys 20,000 shares at $19.41 and proceeds to collar the stock with a March 2015 $21.00 call and a March 2015 $18.00 put.

The covered calls will always yield less than the cost of the put as options discount the expected dividend payments. In general we can identify that the costs of the protection will be offset by the cash flow from the covered calls and dividends.

So what was the outcome? The first and most important objective is that the advisor has completely removed the risk of catastrophic drawdown if an unexpected market crash was to occur. Over the next 15 months the advisor has limited the downside risk to $18.00 or 7.26% lower from the entry price. But the loss would likely be less as sharp market declines are accompanied by material spikes in volatility which would grow the value of the protective put at a faster rate than the delta would suggest.

At the same time, the advisor has allowed the client the upside potential of $1.59 or 8.19%. If the bull market continues, the funds allocated to this strategy would be able to contribute to the expected returns for the client.

There is third and arguably more important advantage. The position has a substantially reduced volatility in seeking that 8% equity style return. The way to demonstrate this is by analyzing the net delta of the stock and collar combo.

What does this mean?

Let’s say an advisor had 20,000 shares of XIU for the client and the XIU dropped $1.00 from $19.41 to $18.41. From a volatility perspective, the client would have seen a $20,000.00 swing in their account balance. At the same time, the client that had the XIU shares open with the $18/$21 collar would have only experienced a $7,482.00 change (20,000 x 0.3741).

What has the advisor accomplished? Reduced volatility with no risk of a catastrophic loss. At the same time as providing the client with the ability to achieve stock market style returns. This certainly is something worth considering.