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Investment Advisors using Options

Patrick Ceresna
December 2, 2013
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4 minutes read
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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.

Shares 20,000 x $19.41

$ 388,200.00

March 2015 $21.00 covered call ($0.40)

+$ 8,000.00

March 2015 $18.00 protective put ($0.90)

– $ 18,000.00

5 x Quarterly dividends (5 x 0.145*) *appox.

+$ 11,600.00

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.

Position

Delta

ETF

1.0000

March 2015 $21.00 covered call ($0.40)

-0.2998

March 2015 $18.00 protective put ($0.90)

-0.3261

Net

0.3741

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.

Patrick Ceresna
Patrick Ceresna http://www.bigpicturetrading.com

Derivatives Market Specialist

Big Picture Trading Inc.

Patrick Ceresna is the founder and Chief Derivative Market Strategist at Big Picture Trading. Patrick is a Chartered Market Technician, Derivative Market Specialist and Canadian Investment Manager by designation. In addition to his roll at Big Picture Trading, Patrick is an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada about the many valuable uses of options in their investment portfolios. Patrick is also co-host to the MacroVoices weekly podcasts. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities. With his specialization in technical analysis, he bridges important macro themes with the attempt to understand when those trends are beginning and understanding where they likely to go. With his expertise in options trading, he seeks to create opportunities that leverage returns, while managing/defining risk and or generating consistent enhanced income. Patrick has designed and teaches Big Picture Trading's Technical, Options and Macro Masters Programs while providing the content for the members in regards to daily live market analytic webinars, alert services and model portfolios.

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