Author Archives: William D. McGirr

Enhancing Equity Portfolios through Option Overlays

Arnold DiLaura, Managing Director

April 2015

Writing covered calls on equity positions in a portfolio is a useful way of generating additional income as the call writer is monetizing a portion of the stock’s potential upside over the option’s 30- or 60-day lifetime.

The risk of covered calls is that at expiry the stock will be higher than the strike price and either the stock will be called away, the short call will have to be bought back, or the option position will be “rolled”– the short call will be bought back and the purchase will be financed by selling a longer-dated, higher-strike price call. Rolling in effect gives the stock further room to appreciate. If a stock is called away, another potential strategy is the use of a cash-secured put which we discuss in more detail below.

When looking at a portfolio, there are two ways to write calls: 1) The first is on a portion of some or all of the individual stocks in the underlying portfolio, 2) The second is to write index call options on the portfolio as a whole. Each technique has its own advantages and disadvantages.

Writing calls on the individual stocks will generate more income, all else being equal. This is because the implied volatility of options on individual stocks is almost always higher than the implied volatility on an index which includes the underlying stocks. All else being equal, the higher the implied volatility, the higher the option premium. Figure 1 below shows a comparison of the annualized stand-still returns at various call-away probabilities for an ETF which trades at a 20% implied volatility versus a 38% implied volatility.

Figure 1

Even though writing calls on the index generates less income, it has certain advantages: 1) The first is simplicity, in that the call writer is writing options on one index, not 30 or 40 stocks, 2) The other advantage is that the individual stocks are free to appreciate unencumbered. If one of the stocks in the portfolio is the subject of a takeover and doubles overnight, the stockholder gets the full gain.  If options had been written on the stock, the stockholder would only get the gains up to the strike price.

Figure 2 shows a graphic comparison between writing calls on individual stocks in an illustrative large-cap portfolio, and writing an index call on the same portfolio. In this example, the portfolio is equal capital weighted. In selecting options for individual stocks, one can first calculate the probability that any particular strike price will be in- or out-of-the-money at expiry. One can then look for those options that have a 25% probability or less of being in-the-money (ITM), and that still generate a sufficient annualized return. The specific stocks, option strike prices, premiums, percentages out-of-the-money (OTM), and stand-still returns are shown in Table 1.  Writing a call on each stock will generate about 80 b.p. in premium (relative to the total value of the equity portfolio) over the 60 day period, or an approximate 4.8% annualized return. Table 1 shows that the option strike prices vary from about 3.5% to over 9% OTM. This means that the stocks can appreciate from 3.5% to 9% over a 60 day period without the risk of being called away.

For comparison purposes we selected and sized an index option on the portfolio as a whole which would generate the same amount of option premium, 80 b.p.  As Figure 2 shows, the index strike price is much closer to at-the-money (ATM) than any of the single stocks – about 2%.  This means that the risk of underperformance in a rising market is significantly higher with the index option methodology than the single stock option methodology – 2% vs. 5%.

Figure 2

                                   Table 1

Ticker Last Strike %OTM Stand-still Return (Annualized)
EMC 26.28 28 6.54% 3.31%
SNY 52.56 55 4.64% 5.99%
CAH 66.2 70 5.74% 3.85%
AAPL 604.71 640 5.84% 6.00%
NOV 82.07 85 3.57% 6.18%
ORCL 41.56 45 8.28% 3.46%
MSFT 39.68 42 5.85% 3.63%
USB 41.11 43 4.60% 3.28%
ECL 106.67 110 3.12% 5.20%
TMO 114.47 120 4.83% 8.12%
XLK 36.71 39 6.24% 0.74%
TWX 68.8925 75 8.87% 3.00%
JCI 46.68 50 7.11% 5.14%
COP 77.85 80 2.76% 6.20%
CELG 147.65 160 8.36% 8.07%
MON 115.9 120 3.54% 9.01%
GOOGL 540.39 560 3.63% 12.60%
PFE 29.25 31 5.98% 5.33%
STJ 64.13 70 9.15% 6.08%
SPY 187.55 195 3.97% 1.23%
WFC 48.96 52.5 7.23% 1.84%
QCOM 79.86 85 6.44% 1.62%
BA 129.58 135 4.18% 6.76%
JNJ 100.25 105 4.74% 1.83%
PEP 85.65 90 5.08% 2.38%
XOM 100.67 105 4.30% 3.40%
WAG 68.88 75 8.89% 6.45%
BBT 37.09 39 5.15% 4.37%
UTX 113.1 120 6.10% 2.31%
DIS 81.09 85 4.82% 6.33%
PG 80.23 85 5.95% 1.12%
EWBC 32.95 35 6.22% 9.10%

What about Puts?

Until now we have been talking about using covered calls to generate income on an equity portfolio. Put options, which convey the right to sell a particular stock at a particular price at some point in the future can also be used as part of an options overlay strategy.

One way they can be used is for protection: one can use a portion of the cash premium generated by selling covered calls on individual stocks to purchase broad-based ETF or Index puts (or put-spreads) thus providing a degree of downside protection for the portfolio as a whole.

The second use of puts in an overlay strategy consists of selling cash-secured, out-of-the-money (OTM) puts as a way of potentially acquiring a stock cheaper than its current price. For example, let’s say we like XYZ stock at its current price of $50, but we would like it even more if we could get it for $45. We could sell a 60-day, $45 strike put for $1. If the stock declined to $45 or below at expiry, we would then be obliged to buy the stock at $45. But we would have still taken in the original $1 credit, which is a stand-still annualized return of 13%.

This strategy can also be used for stocks which have been called away. For example, if one wrote an 80 strike call on a stock that had been trading in the 70s but which subsequently shot up over 80, that stock would be called away. However, after the stock was called away one would have $80 in cash, and assuming one still liked the stock, they could write an 80, or even 75, strike put, taking in an additional cash premium while waiting for the stock to decline to where they would buy it again.

Overlay Timing

When are the best times to implement options overlays?

  1. Anytime an investor or portfolio manager needs to generate more cash than will be provided by the regular interest and dividends from portfolio assets. Selling covered calls can avoid the need to liquidate assets to cover disbursements.
  2. When equity valuations are stretched and consequently huge gains going forward are less likely. In this environment, where long term equity returns are projected to be in the low single digits, a covered call program could double or triple those returns.

 


AUA Capital Management, LLC does not render legal, accounting, or tax advice. This analysis has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any performance data quoted represents past performance. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance is no guarantee of future results. This data is gathered from what is believed to be reliable sources, but we cannot guarantee its accuracy.

AUA Capital Management, LLC blog, white papers and website are made available for information and educational purposes only. The blog, white papers and website give general information and do not provide investment advice. By reading our blog, white papers and website, you understand that there is no advisor-client relationship created between you and AUA Capital Management, LLC. Although the information on our blog, white papers and website is intended to be current and accurate, the information presented may not reflect the most current developments, regulatory actions or investment decisions. These materials may be changed, improved, or updated without notice. AUA Capital Management, LLC is not responsible for any errors or omissions in the content of the blog, white papers or website or for damages arising from the use or performance of the blog, white papers and website under any circumstances. We encourage you to contact us or other investment advisors for specific investment advice as to your particular matter.

You may print a copy of any part of this blog or white paper for your own personal, noncommercial use, but you may not copy any part of the blog or white paper for any other purposes, and you may not modify any part of the blog or white paper. Inclusion of any part of the content of this blog, white paper or website in another work, whether in printed or electronic, or other form, or inclusion of any part hereof in another web site by linking, framing, or otherwise without the express permission of AUA Capital Management, LLC is prohibited.

Managing Diversification and Drawdowns in the “New Normal”

Michael Salerno, President
William McGirr, Managing Director
AUA Capital Management

February 2015

It is easy to lose sight of broader market shifts while a constant stream of often-conflicting information barrages us daily. This may be even more relevant for a US based investor experiencing the returns and movements of the S&P 500 over the past 5 years. Since the end of the 2008-2009 crash the US market has moved up relentlessly, with each pause small, benign and over quickly. Before the memory of the crash, or even a much more common 20% correction, recedes completely, it may be helpful to recall that in 2008-2009 diversification alone failed to provide adequate risk management for an investor’s portfolio. Going forward this may also be true for most substantive market down turns.

Traditional diversification is based on dispersion among asset classes and geographies. Traditional asset classes include equities, bonds, commodities and currencies, with the bulk of capital being allocated to equities and bonds, and smaller slices to commodities and currencies. The correlations among these asset classes have been rising and with increased globalization and interdependency of markets geographic diversification is fading. Even investment strategies touted as new asset classes and frequently housed in hedge fund structures may provide limited diversification benefits. Jan Straatman discusses this in his paper “Innovations in Asset Allocation and Risk Management after the Crisis”, CFA Institute, March 2013, and notes that “increasing the number of asset classes in a portfolio does not always increase effective diversification because many of the so-called new asset classes have the same types of risks and exposures as traditional asset classes.” This is especially true in tail risk scenarios as Jan also notes “investors can no longer depend on the correlations of traditional asset classes to provide diversification when it is needed most because correlations during tail events differs from normal correlation.”

While equity returns during the recent past have been inconsistent, over the last 25 to 30 years, a traditional passive 60/40 portfolio (60% equity exposure, 40% fixed income exposure) has benefited significantly from an extended bond bull market. Over the long-term, starting valuations have a substantive impact on future returns and the valuations of both the US bond and equity markets are currently well above their historical averages – based on metrics such as current bond yields and CAPE (cyclically adjusted price earnings) ratios. This poses a serious challenge for investors who require a certain return level and suggests that traditional methods of asset allocation and investment management may not be able to produce their historical long-term results.

The weakness of available diversification options along with high current valuation levels subjects portfolios to the risk of large drawdowns. These drawdowns can severely impact wealth accumulation, particularly in portfolios called upon to make episodic distributions such as pension, endowment and retirement funds.

To address these concerns in liquid asset portfolios we suggest a portfolio management process that includes a combination of strategic considerations – such as valuations and return premium estimates, with tactical considerations – timely factors based on momentum, sentiment and trading patterns, applied to a portfolio of core equity and fixed income exposures, across asset classes, geographies and investment factors. By managing portfolios across not only asset classes and geographies, but also across investment factors, it is possible to create exposures to a broad array of investment opportunities, with mechanisms in place to reduce drawdowns in tail-risk scenarios.

A full portfolio solution could combine this strategic and tactical approach to the liquid markets portion of one’s portfolio along with a dedicated effort to identify potential high return, uncorrelated, concentrated alpha opportunities. These alpha opportunities may arise due to specific market regime dislocations and disruptions.

 

AUA Capital Management, LLC does not render legal, accounting, or tax advice. This analysis has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any performance data quoted represents past performance. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance is no guarantee of future results. This data is gathered from what is believed to be reliable sources, but we cannot guarantee its accuracy.

AUA Capital Management, LLC blog, white papers and website are made available for information and educational purposes only. The blog, white papers and website give general information and do not provide investment advice. By reading our blog, white papers and website, you understand that there is no advisor-client relationship created between you and AUA Capital Management, LLC. Although the information on our blog, white papers and website is intended to be current and accurate, the information presented may not reflect the most current developments, regulatory actions or investment decisions. These materials may be changed, improved, or updated without notice. AUA Capital Management, LLC is not responsible for any errors or omissions in the content of the blog, white papers or website or for damages arising from the use or performance of the blog, white papers and website under any circumstances. We encourage you to contact us or other investment advisors for specific investment advice as to your particular matter.

You may print a copy of any part of this blog or white paper for your own personal, noncommercial use, but you may not copy any part of the blog or white paper for any other purposes, and you may not modify any part of the blog or white paper. Inclusion of any part of the content of this blog, white paper or website in another work, whether in printed or electronic, or other form, or inclusion of any part hereof in another web site by linking, framing, or otherwise without the express permission of AUA Capital Management, LLC is prohibited.

Where is the Bottom for Oil?

Arnold DiLaura, Managing Director, AUA Capital Management
December 2014

We have found some interesting charts regarding the outlook for oil as we head into 2015. The first is from Scotiabank, and shows the break-even price for various US and Canadian oil fields. They range from over $80 to the mid-40s. Crude is currently trading between $55-60 a barrel.

image1

The second chart below is from the IEA and shows a time-series of world production and demand for oil from 2009 projected through 2015. We currently have a 2 million b/d over-supply which is contributing to the price weakness.

image2

The implication of the two charts is that if the Saudis want to take 2-3 million b/d of production capacity out of the market, oil should stabilize at a price in the mid-50’s.  There is however, an additional geopolitical factor to consider:  One of Saudi Arabia’s arch enemies, Iran, and a key adversary, Russia, both depend on high oil prices to fund their governments and activities which are antithetical to Saudi (and other Gulf Arabs’) interests.  If the Saudis (and their allies) were to continue to drive the price of oil down, they would further reduce marginal production capacity worldwide. However, this capacity would not be Iranian or Russian, as they have an imperative to produce almost no matter what the price. The goal would be to curtail funding for the governments that engage in acts (e.g., support for Assad in Syria) which the Saudi’s oppose.

In any event, we had originally thought that prices would need to go lower (between $40-50/barrel) to shake out the higher price producers. Clearly prices could go that low, but if the implications of these charts are correct, then the floor might be at current levels in the mid-50s.  If so, we could expect oil to trade in the $50-60 range over the next 6 months to one year.

AUA Capital Management, LLC does not render legal, accounting, or tax advice.  This analysis has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any performance data quoted represents past performance. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance is no guarantee of future results.  This data is gathered from what is believed to be reliable sources, but we cannot guarantee its accuracy. 

AUA Capital Management, LLC blog, white papers and website are made available for information and educational purposes only. The blog, white papers and website give general information and do not provide investment advice. By reading our blog, white papers and website, you understand that there is no advisor-client relationship created between you and AUA Capital Management, LLC. Although the information on our blog, white papers and website is intended to be current and accurate, the information presented may not reflect the most current developments, regulatory actions or investment decisions. These materials may be changed, improved, or updated without notice. AUA Capital Management, LLC is not responsible for any errors or omissions in the content of the blog, white papers or website or for damages arising from the use or performance of the blog, white papers and website under any circumstances. We encourage you to contact us or other investment advisors for specific investment advice as to your particular matter.

You may print a copy of any part of this blog or white paper for your own personal, noncommercial use, but you may not copy any part of the blog or white paper for any other purposes, and you may not modify any part of the blog or white paper. Inclusion of any part of the content of this blog, white paper or website in another work, whether in printed or electronic, or other form, or inclusion of any part hereof in another web site by linking, framing, or otherwise without the express permission of AUA Capital Management, LLC is prohibited.

Weekly Market Indicators for 09.28.14

Credit Market Indicators:
Treasury Yield Curve
Treasury prices increased last week and yields “tightened-in” about 5 basis points along the intermediate portion of the curve. The benchmark 10-year note ended the week at a 2.54% level.

Current Shiller CAPE Ratio:
The CAPE ratio remains significantly higher than its historic mean of 16.6 with a Shiller PE Ratio of 26.2 at the close of market Friday. While not useful as a timing indicator, elevated CAPE levels have correlated strongly with less than historic levels of annualized equity returns on a forward looking basis.

Volatility Indicators:
The VIX ended last week at a 14.85 level, up 21.62% from the prior week, posting the biggest weekly gain since the end of July.

Momentum Indicators: 
Equities of all types were down last week, but near term momentum continues to strongly favor domestic large cap stocks over all other equity categories.*

Weekly Market Indicators for 09.21.14

Economic Releases:
The index of leading economic indicators (LEI) for August released last Friday, advanced 0.2%, which was less than expected. Single family housing starts declined 14.4%, however, that reading follows a sharp increase of 22.9% in July. From month to month, housing data is notoriously volatile, but the longer term trend is useful. The 12-month moving average stands at the highest level since October 2008.

Credit Market Indicators:
Real and Nominal Yield Curves YTD change and since the end of August– Treasury Yield Curve
The nominal curve has flattened significantly since the beginning of the year, with long term rates dropping and more recently, intermediate term rates increasing. Within the last 3 weeks, however, this trend has reversed. Just in the month of September, there has been a near 25 basis point move higher along the 7 to 10 year portion of the treasury yield curve.
Interestingly, the real yield on the 5 year note has turned positive and has jumped 40 basis points month to date.

Current Shiller CAPE Ratio:
T
he CAPE ratio remains significantly higher than its historic mean of 16.55 with a Shiller PE Ratio of 26.5 at the close of market Friday. While not useful as a timing indicator, elevated CAPE levels have correlated strongly with less than historic levels of annualized equity returns on a forward looking basis.

Volatility Indicators:
With the S&P 500 Index advancing last week, fueled in part by the enthusiasm surrounding the Alibaba IPO, the VIX ended last week at a 12.21 level, down from the prior week’s 13.31 reading.

Momentum Indicators:
Near term momentum continues to strongly favor domestic stocks over developed international equities. Nearly all domestic sub-categories were up last week and nearly all international categories were negative. REITS and emerging market stocks have been two of the more resilient asset classes over the past few months, but last week they were among the weakest equity categories. Sluggish economic growth in Europe and China along with escalating global tensions is weighing on international stocks.*

Weekly Market Indicators for 09.14.14

Economic Releases:
August retail sales matched forecasts, advancing 0.6%.  The latest reading is the 7th consecutive monthly increase. Consumer sentiment reached a 14-month high. The index of leading economic indicators (LEI) for August will be released this Friday.  We look for this reading to confirm a strengthening U.S. economic growth picture.

Credit Market Indicators:
Real and Nominal Yield Curves YTD change – Treasury Yield Curve
The nominal curve has flattened significantly since the beginning of the year, with long term rates dropping and more recently, intermediate term rates increasing. Within the last 2 weeks, however, strength in bonds has reversed course. Just in the month of September, there has been a 20 basis point move higher in the 10 year note. At the shorter end of the curve, the 2 year note has moved up 5 basis points since August.

Current Shiller CAPE Ratio:
The CAPE ratio remains significantly higher than its historic mean of 16.55 with a Shiller PE Ratio of 26.24 at the close of market Friday.

Volatility Indicators:
The VIX ended last week at a 13.31 level. Volatility picked up last week on general market weakness and increased uncertainty related to geopolitical events in Eastern Europe and in the Middle East.

Momentum Indicators:
Near term momentum strongly favors domestic stocks over developed international equities. Emerging market stocks and REITS two of the more resilient asset classes during the past several weeks were among the weakest categories last week.*

Weekly Market Indicators for 09.07.14

Recent Economic Releases:
None for this week’s post.

Credit Market Indicators:
Real and Nominal Yield Curves YTD change – Treasury Yield Curve
The nominal treasury yield curve continues to flatten out as the market closed on Friday with treasury yielding 2.46%.
Source: US Department of the Treasury

Current Shiller CAPE Ratio:
Currently at a ratio of 26.49, CAPE is 59% higher than its historic mean of 16.6.  The “takeaway” is that while this is not a timing indicator, the current level is well above historic mean values and when this valuation measure is this high, historically, the annual future returns have been very low.
Source:  Multpl.com

Volatility Indicators:
Closing on Friday at 12.09, the VIX appears to be complacent, compared to being as high as 17 in late July through early August. The inference is that this continues to be a market that can be carefully invested in.
Source:  Yahoo Finance

Momentum Indicators:
Relative to a general trend, momentum is currently positive.*

Welcome to the AUA Capital Management Insights Page!

Welcome to the AUA Capital Management Market Insights page!

AUA Capital Management is an asset management firm that provides investment services for private clients, institutions and enterprising families. We are research intensive, and committed to applying leading edge investment processes and methods to the management of our client accounts.

We believe it is important to know and understand what is going on in the investment world. Our readers can use our Insights page as a reference tool to understand and keep up-to-date on the markets.

Each month the AUA Capital Management Team will be posting our thoughts on the current events that may affect your portfolio.  Our insights will encompass the thoughts and reflections of these events, as well as updates and other information that we believe will benefit our readers.

Feedback is always appreciated and encouraged, so if you have a question, comment, suggestion or would like to speak to a member of the AUA Capital Management Team, you may contact Will McGirr via email at will.mcgirr(Replace this parenthesis with the @ sign)auacapital.com, or go the ‘Contact Us’ page of our website for additional contact information.