Why Use Options Overlays On ETFs?

April 22, 2019

Worth The Time To Learn

This is where financial advisors can have a key role, as they're ideally positioned to get the word out to their clients about the opportunities and the risks that can be found with options.

Fariba Ronnasi, founder and chief executive of Elite Wealth Management in Kirkland, Washington, understands the challenge of educating clients. Her firm, which focuses on separately managed accounts for larger portfolios, deploys options to create income streams for clients who have fundamental strategies.

The story she tells is instructive, because she makes it clear there is a widespread need for education on options, including how they can be applied as overlays to long positions.

"Many clients have no idea what overlays are," she said. "They don't know covered calls or stock versus index options. It is a lot of educational work on our end to explain to the client what we do and why selling options makes sense. Once you start that conversation, clients get very excited about it."

One of her firm's strategies involves selling far-out-of-the-money covered calls on a client's assets, while using the value of the portfolio to sell far-out-of-the-money put options on an ETF that tracks the S&P 500. The client collects premiums on both the calls and the puts, in addition to holding whatever security they prefer in their portfolio, and still receive the dividends and interest income on the underlying holdings.

If the S&P-tracking ETF falls toward the put strike, the client could close the position and redeploy it at a lower strike. But if the ETF were to drop below the strike, leading to assignment, the client would use assets on hand to acquire the ETF. At that point, covered calls would be written on the long position, creating immediate income as well as a liquidation price.

"Ask as many questions as you want until you fully understand how it works," she advised. "Once you get it, you're going to love it."

No Risk-Free Lunch

To be clear, options aren't risk-free. Adding options creates a layer of complexity that has to be managed and monitored for any ETF portfolio.

Still, overlays shouldn't be viewed as an opposing force within the fundamentals-based approach to investing—they’re tools to support it. With time and research, it just may be that you'll develop a new perspective on options.

Eric Cott is the director of financial advisor education for The Options Industry Council, a resource managed by OCC, the world's largest equity derivatives clearing organization.

Options involve risk and are not suitable for all investors. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, “Characteristics and Risks of Standardized Options,” available by visiting OptionsEducation.org. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.

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