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Investors are dusting off an old strategy -- options overlay. When it works, it offers both yield enhancement and risk management.

Investors are dusting off an old strategy -- options overlay. When it works, it offers both yield enhancement and risk management.

By Rich Blake
September 2002
Institutional Investor Magazine

How can an investor wring a positive return out of this grim equity market? These days some smart money is utilizing an equity derivatives strategy that first gained acceptance during the late 1970s: writing covered calls. Although no one tracks exactly how much money is going into covered calls, also known as options overlay, the approach is making a comeback. Industry observers reckon that about $5 billion in U.S. assets -- roughly five times the level of just a few years ago -- are tied up in the strategy. Several billion more are probably invested in covered calls in Europe.

“We’ve seen growing interest in our options overlay strategies,” reports Todd Miller, head of derivatives strategies at Pasadena, Californiabased First Quadrant, a $14 billion quantitative asset manager that has taken in $350 million in new funds designated for options call writing in the past year. “It’s a pure alpha strategy, and in this market people can use all the extra alpha they can get.”

Says Charles Annandale, head of equity derivatives for SG Securities in London, “Covered call writing makes a huge amount of sense for those with a neutral to bearish market outlook.” Peter Allen, head of European equity derivatives strategy for J.P. Morgan, endorses that judgment. “Covered call writing allows fund managers to rearrange their risk-return landscape in a way that is more difficult to do with underlying equity alone,” he says. “You swap upside return above the strike price in return for enhancing returns in down, flat or even modestly upward markets.”

A growing roster of money managers, including Goldman Sachs International’s equity derivatives group, working on behalf of a small number of clients, offer options overlay as a strategy for yield enhancement and volatility management.

Options overlay aims to collect cash in tiny increments by writing calls on stocks that investors believe will either remain flat or move only slightly up or down. Writing a call essentially amounts to selling someone the right to buy a security, in this case shares of a stock, at an agreed upon strike price for a nominal fee -- usually about 60 cents to 80 cents a share. The hope is that the stock won’t reach the strike price during a specified period of time, usually 60 to 90 days.

For example, if you own a $50 stock with a strike price of $55, someone on the other side of the trade might agree to pay you a 2.6 percent premium, or roughly $1.30 a share, for the right to buy the stock in a bet that the shares will go higher than $55 over a 90-day strike period, making the conservative assumption of 30 percent volatility versus the current average of 40 percent.

The person who writes the call expects the expiration period to come and go without the strike price ever having been reached. Each time a call is written on a stock that isn’t called away, the investor pockets that nominal fee and still owns the shares.

When it works, writing covered calls can be a relatively low-risk, income-generating exercise that sweeps money into an investor’s account every two or three months. For example, for a call writing program involving $100 million worth of shares (say, 100,000 shares each of 20 stocks, at an average price of $50 per share) the premium -- assuming it works -- could be in the neighborhood of $2.5 million for each strike period.

The Colorado Public Employees’ Retirement Association embraces covered call writing. “We reduce the volatility of our portfolio; we receive income selling the calls; and we are able to increase our equity exposure and still maintain median risk when compared to other pension funds,” says Norman Benedict, deputy director of the plan. “However,” he adds, “we use the program to a smaller degree now that we think market conditions are improving.”

For the moment, at least, U.K. pension funds rarely use covered calls. Says the head of investments for one of the largest British corporate pension funds: “The U.K. is slower at using this type of instrument than our U.S. and continental European counterparts simply because we do not understand them. We’re less well versed in esoteric instruments.”

Covered call writing programs utilize listed and over-the-counter stock options, much as they did back in the late 1970s. But technology now enhances the game, making the strategy more profitable for practitioners while allowing for more risk control and increased transparency.

When the strategy first debuted (the underlying mathematical theory dates to the 1973 creation of the Black-Scholes options pricing model), profits were often eaten up by high bid-ask spreads because there was so little liquidity in the options market. Meanwhile, the computing hardware in the early 1980s was cumbersome and expensive. Today the listed markets’ and OTC markets’ bid-ask spreads have come down considerably, and computer software is, of course, vastly more powerful.

That’s a good thing, say proponents of options overlay, because these days a long-only position (or simply holding shares) is riskier than ever. These strategies can help minimize risk by generating income to offset losses in an extended market slide. Meanwhile, part of the cash premium can be used to buy puts, which provide downside protection if desired.

“Whether they like it or not, long-only equity investors own all this volatility -- all these possible up-and-down outcomes that come and go every day,” explains Karlheinz Muhr, founder of New Yorkbased Volaris Advisors.

Since it set up shop a little more than a year ago, Volaris has amassed $700 million in equity options portfolios for a handful of institutions and wealthy individuals. “We help shape, optimize and take advantage of these future outcomes,” says Muhr. “It’s the equivalent of creating a synthetic dividend. We don’t create value, rather we capture value that already exists.”

A native of Austria, Muhr is the former head of UBS Warburg’s Global Executive Group, a high-net-worth division of the firm. He had spent much of his career at Warburg and before that at Credit Suisse First Boston working with institutions on mortgage-backed and other fixed-income derivatives strategies. It was in this capacity in 1999 that Muhr first came to realize that the extended bull market had slowed the advancement of equity derivatives strategies.

“The most sophisticated derivatives products used by institutions were all in the fixed-income area,” Muhr recalls. “On the equity side, institutions got used to the idea that there was no real need to do anything more than just go long,” he explains. “Any large investor who simply holds an asset -- and doesn’t do anything else but hold it and wait for it to appreciate -- is like someone who owns a vineyard strictly as a real estate investment but never uses the grapes to make wine.”

Through this strategy Volaris aims to create extra yield of 200 to 400 basis points per year. Using proprietary volatility-management analytical software and considerable computer horsepower, the firm’s portfolio managers write covered calls on stocks identified quantitatively as having a 20 percent chance or less of being called away. “If the computer gets it right four out of five times,” says Muhr, “we are in the money.”

Recently, a prospective Volaris client back-tested the firm’s system against the top 20 stocks in its 2001 portfolio, which had fallen 16 percent during the year. The Volaris system, says Muhr, would have provided an extra 600 basis points, leaving the portfolio with a 10 percent loss. “That’s a huge difference,” Muhr says.

With the market reeling, volatility has been steadily climbing -- making investors more and more sensitive to effective risk management. VIX, the Chicago Board Options Exchange’s widely followed market volatility index, rose nearly 30 percent -- to reach its highest level of the year -- in the first two days of August. In Europe, where covered call writing is most popular among high-net-worth individuals, the volatility of the DAX has been on a similar upward trend, with spikes in mid-July and then again in early August.

“In five years volatility management will be its own separate asset category alongside money management,” Muhr predicts.

But not everyone is convinced.

“Portfolios on which covered call options are written will outperform in flat to down markets, but underperform in strong up markets,” warns Todd Petzel, until last month CIO of Commonfund, a manager-of-managers that works mostly with college endowments. When a market surges unexpectedly higher, Petzel explains, more stocks will get called away, conceivably wiping out all previous gains. “Options overlay strategies might seem like a free lunch, but as we all know there is just no such thing in this business.” In the face of the market’s recent gyrations, says SG Securities’ Annandale, “the idea of locking in a predetermined sale price for a stock takes a lot of guts.”

Says Ross Turnbull, an analyst with Vancouver-based brokerage Odlum Brown who specializes in equity derivatives products, “If something looks too good to be true, it probably is.”