The use of options, especially covered calls, can be a significant generator of income for retail investors, provided they are equipped with the right knowledge and tools, according to financial experts.
Many retirees hold concentrated stock positions that lend themselves well to a covered-call writing program. US Alliance Credit Union, for example, has many members whose net worth consists almost entirely of IBM stock.
US Alliance began 40 years ago as a credit union for IBM employees, based in a company cafeteria. Today, it has over 60,000 world-wide members and assets in excess of $850 million.
“Significant amounts of stock in concentrated positions exist, with some members having 90% of their net worth in IBM,” said Doug Robb, a financial adviser at Cuso Financial Services and a special adviser at US Alliance Credit Union, said at the Thought Leadership Forum held at the New York Stock Exchange on Thursday.
Robb is developing a program to educate US Alliance members about options trading. Although many of these members are affluent, they are relatively unsophisticated about derivatives and are understandably leery.
“Trying to get a managed-call strategy absorbed by an older member is difficult,” said Robb. “My approach is to tell them to think of covered calls as a way of generating another 5-6% in additional income. You can outperform stock in a concentrated position by using these strategies. It starts with IBM stock and invariably leads to a rollover.”
Cuso Financial Service's self-directed electronic trading platform, eVision, is designed to serve as a "starter" program for credit unions not ready to establish a full investment program, or as an addition to an already successful program. eVision allows members to place their own stock, option and mutual fund transactions at discounted commission rates.
Many credit unions of Fortune 500 companies have members with concentrated stock positions that could benefit from an options writing strategy, Robb said. “I am one of the first to go after this business because people are looking for downside protection,” he said.
Doug Bremer, managing director at SpiderRock Advisors, a technology provider specializing in equity options, volatility trading and automated portfolio management, said at the Thought Leadership Forum that financial advisers are looking for optimized approaches for interacting with the market.
“There is a demand for solution-based products,” he said. “A managed options strategy in a separately managed account is the best form of liquid alternative.”
A covered call, in which the writer of the option owns the underlying asset, “is the most actively used, consistent means of risk-adjusted performance,” Bremer said. “There is an embedded ability to harvest the difference between implied volatility and realized volatility. That cushion provides a modicum of yield. There are alpha-driven strategies and absolute return strategies as well.”
Although covered calls are considered one of the more conservative options strategies, they aren’t entirely risk-free. Selling call options limits upside potential: if the stock price rises, the options will be exercised and the writer will have to sell at the below market strike price.
The Sharpe ratio on a covered call strategy is quite good compared to a long-only portfolio, Bremer noted.
"You’re not disrupting the underlying portfolio, but are merely generating short index calls or individual stock calls, harvesting income,” he said. “You always want to be consistently harvesting income. We’re not here to time the market. I’m discounting my ability to consistently outperform the market by harvesting yield instead.”
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