Enhancing Portfolio Stability: How Options Overlays Can Help Model Portfolios

Correlations between asset classes can run strong.

However, there may be a way to increase diversification within a model portfolio without adding asset classes. Options and options overlay strategies can provide a needed diversification benefit for model builders and users. The best part is that options strategies don’t have to be complicated or expensive to add.

For many investors and financial advisors, options and derivatives are often ignored when it comes to portfolio construction. And it’s easy to see why. Options can be confusing and strategies such as Condors,’ ‘Iron Butterflies,’ and ‘Christmas Trees’ tend to evoke sophisticated traders looking to make serious money over the short term.

But it’s important to understand what options and most other derivatives are. And that’s insurance. At their core, options of any kind include the right but not the obligation to buy or sell something at a certain price. That could be single stocks, ETFs, indexes, corn or fixed income assets.

Ignoring the multi-monitor day-trader, thinking about options in their classic definition—as portfolio insurance—makes a lot of sense. They are a way to mitigate risk and potentially smooth out the ride of a portfolio.

It’s that smoothing that is key to model portfolio builders and long-term returns.

Many investors, financial advisors, and portfolio construction tools operate under the idea that buying stocks, bonds, and other assets and cobbling them together makes for good diversification. That is, when one asset class is losing money, another will gain, smoothing out the portfolio’s overall returns. This is good in theory.

The problem is that traditional asset classes used for diversification are now getting more and more correlated. Stocks and bonds are moving in the same direction or not providing enough downside. A more interconnected global economy is limited by the effect of holding international stocks. Even commodities and real estate assets aren’t producing the same level of non-correlation that they once did.

For example, according to J.P. Morgan, during 2022, stocks and bonds reached correlation levels not seen since the 1990s. A classic 60/40 stock/bond model portfolio would have sunk by over 16% that year. ¹

Using options could provide the needed diversification benefits that investors are now lacking, particularly if they use a static model portfolio of ETF and asset classes. That diversification pays big benefits. Adding a collared and call writing strategy would have limited investors’ losses to just 8% that year. Moreover, the lack of loss would have helped the portfolio bounce back higher in the resulting year.

This chart from the investment bank shows broad asset classes, a 60/40 portfolio, and three different options indexes. As you can see, the more income-focused collared equity strategy (CLLZ) and call writing strategy (BXM) indexes outperformed the U.S. Agg bond index, while the partial call writing strategy index (BXMH) outperformed the diversified 60/40 portfolio.

Source: J.P. Morgan

The key to this smoothing and how options can provide diversification comes down to how they work.

A buy-write is one of the simplest options strategies to use. Here, an investor buys a stock or a basket of stocks tied to an index and writes call options that cover the position. A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date.

The option writer collects a fee for agreeing to the transaction, which becomes theirs no matter what. At the same time, they can keep the stock and collect the dividends it generates. However, if shares of the stock or ETF go past the strike price of the option, the option buyer will get to buy the shares. However, if it never gets to that point, the option expires worthless and the option writer gets to keep the shares.

Essentially, investors give a portion of equity volatility—and returns—in exchange for income now. This provides a powerful base of non-correlated returns to a portfolio. Moreover, the options overlay provides lower volatility, since you’ve already received some return as cash/premium. The long-term volatility of the major benchmark–the CBOE S&P 500 Buy Write Index–is about 30% lower than the S&P 500. That’s huge when looking at diversification, mitigating the magnitude of a portfolio’s swings and trying to generate a steady return.

Clearly, basic options and the steady income they generate is good for portfolios. By using them, investors can smooth out their returns, lower portfolio volatility, and provide non-correlated sources of alpha.

In a corporation, there is a decision based on being willing to accept risk and what potential returns you’re willing to give up. After all, call options reduce some of the upside of a stock or index position. Remember, life insurance isn’t free and neither is portfolio insurance. In the J.P. Morgan example, the BXMH is a partial option overlay index. For most investors, that type of option overlay could be best for the long haul.

You could write the covered calls yourself. But this is one area where it pays to use a professional. Numerous brokerages and asset managers now offer options SMAs for portfolios. However, there are plenty of active ETFs on the market with options as a core component of their mandates. Using one of these, buying it in your model just as you would any other ETF, and rebalancing could pay off big time over the long haul.

These ETFs were selected based on their low-cost exposure to covered calls and options overlays. They are sorted by their YTD total return, which ranges from 2.6% to 131%. They have expense ratios between 0.35% and 0.75% and assets under management between $93M and $35B. They are currently yielding between 4.4% and 11.5%.

Overall, options get a bad reputation and get pegged as complicated investment products. However, they can work wonders when used as their intended purpose: insurance. By using them in a model and adding an options overlay, investors can reduce volatility and drawdowns and gain valuable diversification benefits. This is key for long-term smooth returns. ETFs make adding such an overall easy to incorporate into a model portfolio.

Model portfolios may be more correlated than investors think. To that end, options could serve as an answer. Providing insurance, lower volatility, and non-correlated alpha, adding an options overlay to a model via ETFs could be a game-changer for portfolios.

¹ J.P. Morgan (June 2024). Improving portfolio diversification with option-based strategies