In today's near-zero interest rate environment, America's savers and investors are faced with a dilemma.  Do they increase their equity allocation and endure the increased portfolio volatility or continue to reach for yield in the fixed income markets through longer maturities or increased credit risk?  Perhaps there is an investment vehicle that can facilitate the needs of investors by safely navigating the aforementioned risks in today's investment landscape.

A well-known options strategy may largely help solve this dilemma.  A buy- write, or covered call strategy, is an investment strategy in which an investor buys a single security or a portfolio of securities and simultaneously writes (sells) calls against the underlying positions. Historically, the buy-write strategy can lower the volatility of an equity portfolio, while potentially generating “yield” from the collected option premium - two important features in the low interest rate/high equity valuation world described above.  In a buy-write strategy, investors are willing to forego some of the gains in a persistent equity bull market in order to dampen portfolio volatility while simultaneously attempting to increase portfolio yield. This balance historically has been found in the typical equity/fixed income asset allocation model, but achieving that balance has become precarious at today’s level of interest rates.

Buy-write strategies have been available to investors for years. Many funds implement the strategy in a systematic way, often ignoring the inherent risks and rewards of the options portion of the portfolio. However, investors need to truly understand the intricacies of how such a fund is managed in order to determine its embedded risks and potential rewards. A portfolio of options adds both a layer of complexity and another potential source of return to a typical long-only equity portfolio. These risks need to be understood and managed, as they derive a large portion of buy- write returns.

The Chicago Board Options Exchange (CBOE) has created an index of the most common buy-write strategy called the CBOE S&P 500 BuyWrite Index (BXM).  While the index itself is non-investable, a few funds have created their own version in order to capitalize on the strategy’s value.

The use of options in a portfolio has become more prevalent since the turmoil in 2008/2009, as options displayed their value-add to investors when used properly to manage risk and volatility. Moreover, the front-end trading platforms of the online brokerage firms have allowed investors to gain access to, and obtain education from, the options markets in a user-friendly, cost-effective manner.  Effectively managing a portfolio of options can often take years of experience to perfect, which is one reason why most financial advisors do not manage their own options-oriented strategies.  Instead, advisors tend to invest in funds specializing in such strategies in order to alleviate themselves from meticulous and expensive execution.

The relationship between risk and reward is one of the primary concerns of every investor. Stated another way, the task for most investors is either an attempt to increase returns for a given level of risk or an attempt to lower the level of risk for a given return.  If an investor is looking to increase his portfolio Sharpe ratio (the mathematical relationship of return per unit of risk) by lowering his portfolio volatility (risk), while striving not to forego returns, then a buy-write strategy might be a useful inclusion in the portfolio. With cash and many fixed income investments earning near nothing, the buy-write strategy only becomes more appealing.

Eric Metz is a derivatives strategist with RiverNorth and the Portfolio Manager of the RiverNorth Dynamic Buy-Write Fund (RNBWX), which utilizes a unique strategy to capitalize on the implied volatility mispricing in the equity options market. The Fund seeks to generate alpha through volatility management of risks inherent in options portfolios. For more information, visit www.rivernorthfunds.com.