3) Selling call options (or purchase puts) on the S&P 500 in the appropriate amount to rebalance the portfolio; and

4) Managing the option component in the existing account, monitoring positions in real time and adjusting them as markets move.

And here’s why it’s important.

Over the past several years, equity market performance has exceeded fixed income by so much that a client whose portfolio was initially weighted in the standard 60/40 equity-to-bond ratio might be closer to a 75/25 risk profile.

Additionally, the equity holdings of a particular client might have a low cost-basis, and selling a portion of their holdings to bring the portfolio back into line with its mandate would generate the aforementioned substantial capital gains and the associated tax liabilities.

In their search for a tax-efficient solution, advisors can apply the options overlay to reduce portfolio beta to the target weighting without triggering a taxable event, while also buffering the portfolio’s downside exposure and potentially generating a new stream of income from call premium. It involves structuring a precise number of options transactions around the client’s existing portfolio holdings.

For example, a client with a $1 million portfolio would like to reduce their equity exposure by $150,000, or 15 percent of the total portfolio value.

Implementing a 30 percent options overlay would bring the portfolio’s risk profile back to its original mandate, something that’s appropriate since a 1 percent reduction of beta exposure requires an additional 2 percent of the portfolio to be “overlayed.”

While effective in reducing risk, there are potential issues of which investors (and advisors) should, of course, be aware.

First, options, while simple in theory, can be complex instruments for some, and their performance is dependent on a few moving parts. It’s why investors and advisors should be well-versed in their various uses before even attempting to incorporate them as part of the portfolio. Luckily, third-party investment firms that specialize in options strategies can assist in the explanation and implementation.