In a previous blog post (What is an Overlay?), we discussed how investors who utilize overlays do so with the goal of reshaping the potential investment outcomes with the most common goals being:
- Generating supplemental income/return (typically through covered call or put writing strategies
- Reducing the risk of the existing portfolio beta exposure (typically through collar strategies)
For investors seeking additional income, it is our belief that the best way to achieve this outcome is through a disciplined put spread writing program that provides investors with a relatively conservative stream of income that supplements the income/total return of the assets in the underlying.
Some investors look to covered call writing to solve the income dilemma. However, call writing offers potential drawbacks relative to a put writing program. First, a put writing overlay gives investors the opportunity to earn positive cash flow in a variety of markets without limiting the appreciation potential of the underlying assets. Call writing, on the other hand, limits the appreciation potential of the underlying assets which can offset any potential benefits of income received when the calls are written (call writing programs have a high risk of reducing the total return of a portfolio in a rising equity market). Second, below market put options offer significantly higher income potential relative to above market calls due to supply/demand pressures and other option pricing factors. This higher income gives investors a greater probability of success and allows them to better capture the volatility risk premium in the market.
While covered call writing may still address the needs of some investors, for those seeking to increase the return potential of a portfolio through an overlay should evaluate whether the overlay can truly add positive cash flow over time or if there is a risk of negative cash flow due to lost appreciation exceeding income generation.
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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss. Options involve risk and are not suitable for all investors. Please see the following options disclosure document (ODD) for more information on the characteristics and risks of exchange traded options.
