In 2022, the poor performance of both equity and fixed-income investments led financial advisors to re-evaluate their risk management strategies, as simple diversification proved unworthy. Many advisors stressed the importance of increasing allocations to alternative assets, including private equity, real estate and digital currency. However, a smaller but growing group of advisors looked to options as a tax-efficient, highly liquid and transparent strategy to manage risk and diversify portfolios.
While you must take tax considerations into account when rebalancing portfolios, options offer a unique advantage: An options overlay is the only way to alter portfolios to one’s liking without creating any tax friction. After all, every transaction in the underlying portfolio can have a tax consequence. Options can mitigate these consequences. This core feature, makes them very useful to advisors and their clients as a hedge against overexposure to certain equities and as a way to generate alpha, especially on an after-tax basis.
In the simplest terms, call options and put options are contracts that allow a buyer to buy or sell an underlying security at a specific time and price. Generally, call options are used when an advisor or client believes that underlying asset will rise. Put options are used to profit from a fall in the value of the underlying security.
More than simply a trade, advisors evaluating this efficiency and value-add should view volatility and options as an asset class, particularly as fiscal and monetary stimulus are being unwound.
In the past, many financial advisors have avoided options largely because they’ve feared the complexity and the perceived challenge of scaling them through their clients’ portfolios. But new tools and partners now make it easier for advisors to manage and integrate option overlays into their clients’ portfolios.
The main attractions
Here are four reasons why financial advisors should consider options as an asset class:
1. Option overlays mean clients don’t need to sell existing holdings to diversify or change their risk profile.
It’s common to use options when the value of a stock appreciates so much that the portfolio becomes overly concentrated in that security. Just look at the broader market indices for proof of the effect of how some stocks’ rise can upset the balance of a portfolio. As of the end of May, according to data from Standard & Poor’s, just seven stocks represented 22% of the total value of the S&P 500. Why? Because those stocks have risen so dramatically over time at a pace far faster than the other 493 names in the portfolio. Apple alone is more than 7% of the entire index. Those sharp rises in some securities happen in every portfolio on the individual level, too.Options allow an advisor to hedge that risk, without changing the actual underlying security, and to maintain the appropriate risk level for clients.
2. Option overlays won’t trigger a tax liability because clients are not required to sell any securities.
It’s important to recall that an option is a right to buy or sell a security, not an obligation. The option itself is a contract with a value that could have a tax implication, but that is almost always less mild than a capital-gains liability on the sale of an appreciated underlying security.
3. Option overlays are the most effective tool to address concentration risk.
As mentioned earlier, portfolios have a habit of becoming overconcentrated in a handful of individual names, due to performance, inheritance or an investor’s employment compensation. Options work as an asset class to de-risk this concentration without having to sell, gift, or otherwise eliminate those holdings, often improving after-tax outcomes.
4. Options can be customized to individual needs.
Given their flexibility, advisors can deploy them in a myriad of ways, always ensuring that the strategies fulfill their fiduciary responsibilities. Options can be used for bullish or bearish predictions, and can fit depending on the nature of each individual client and portfolio. As with all investments and asset classes, it’s important to remember that options carry risk of loss. Those risk should be discussed with the client.
Better balance, lower taxes
Equities, active and passive, have driven most of the performance over the last decade in clients’ typical 60/40 portfolios. But in 2022, these strategies lost more than 18%. In 2023, volatility has continued and equity market performance has surprised many, despite headline risks. There may be no better time to use options strategies to take the sting out of volatility. Yet options need to be used correctly. In the past, some options strategies used leverage that led to deep losses – that’s an example of how not to apply these strategies.
As with any asset class, understanding the value and risks is paramount to fulfil an advisor’s fiduciary duty.
Eric Metz is CEO of SpiderRock Advisors, a Chicago-based registered investment advisors that specializes in options and derivatives strategies.