Risk is not the same as volatility, but that lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. —Warren Buffett

Joining Buffett in distinguishing volatility from risk, the late John Bogle famously said that, as volatility is a certainty, the question isn’t whether investments will go up or down, but whether investors will overreact by doing “something dumb.”

There’s a useful corollary to Bogle’s insight: Volatility is also a chance to do something smart—to harness it for gain.  

Bogle’s and Buffet’s distinctions have been lost on many investors. Ill-founded views of volatility have made herky-jerky markets intimidating for individual investors who shudder when financial talking heads somberly utter the V-word, as though it were a contagious disease.

Like many investor phobias, fear of volatility is based on misconceptions, as is fear of a good way to harness it for portfolio gains: options. This is a subject even some options-savvy advisors are so reluctant to broach with individual clients that they forgo the additional returns that options strategies can bring. Yet more advisors have been using options strategies since equity market volatility cranked up in 2018.

Volatility shows no signs of abating in 2022, as anticipated Fed actions, Omicron and other potential twists of the pandemic are likely to sustain or increase it.

There’s also a less obvious but nonetheless significant historical factor: a record of high volatility in mid-term election years. Since 1962, there has been an average drawdown of 19% in the S&P 500 in these years. But in ensuing 12-month periods, these dips have been followed by bounces averaging 32%. One of the bigger bounces—58.3%—followed a 16.6% drawdown in 1982. Another Super Ball bounce—plus 37.1%—followed a dip of 19.8% in 2018.

Swiss Army Knife
So, a focus on harnessing volatility now is probably timely. A proven way to do this effectively is to use portfolio option overlay strategies. Russell Investments calls these strategies a “Swiss Army knife, a multi-faceted tool for addressing portfolio challenges.”

Academic research shows that overlays hold significant potential for reducing risk and increasing gains. For example, researchers in a study at Monash University in Melbourne Australia looked at overlay strategies used on stocks hammered by the pandemic-induced market decline in 2020. They concluded some overlays “were able to significantly reduce the extreme drawdowns of the index in March 2020, while maintaining steady performance during the strong rebound in April.” Generally, this conclusion was confirmed by a white paper published on ETFtrends.com in April: “Regardless of one’s portfolio make-up, utilizing option overlays is one way to provide consistent income with a low probability of loss.”

Overlays can add some risk over the short term, but they can significantly reduce it over the long term (more than 20 years), through consistent defensive positions while increasing returns through monthly cash flow. Instead of a trading strategy, this is one that systematically captures option premiums through put credit-spread index positions.

Back Test
My firm did a back-test study of such a volatility-selling strategy covering 26 years. The test involved hypothetical investment in the MSCI Large-Cap Value index—both with and without the addition of an overlay using notional options on the SPDR S&P 500 ETF (SPY). In this test, theoretical portfolio managers simultaneously bought put options to provide insurance against catastrophic loss from a substantial market decline. The back test’s return over 26 years was a 1,183% gain for the index-plus overlay strategy, versus a 782% gain for the index alone. In only six of the 26 years did the overlay produce a negative return.

Of course, the study used various assumptions reflecting management choices that real managers might not have made. But even if real managers were to have made some sub-optimal choices, the test results’ spread in returns—more than 400 basis points annually—strongly validates the methodology.

This kind of strategy naturally is only suitable for clients who can make a long commitment. And to get the most out of it, clients naturally need a long enough time horizon, though shorter horizons can result in incremental gains—with the proviso that clients can wait to liquidate to avoid taking losses in down years. 

Of course, this kind of strategy has considerably more appeal for institutional clients, such as foundations. For reluctant individuals, the financial-planning question is: Are the chances of incremental additional returns worth the angst that the mere fact of engaging in an options-based strategy might cause?

Getting Buy-In
The issues of reducing this angst and getting buy-in from clients are really one and the same. To deal with both, advisors need to explode popular myths. The foremost of these is the blanket association of any use of options with high-risk speculation.

Some clients may mention the spectacular failure in 1998 of Long-Term Capital Management, co-headed by Nobel Prize-winning economist Myron Scholes. The appropriate, accurate response is that this was a hedge fund that failed not from volatility but from too much leverage; even Nobel laureates can lack discipline. And regardless, the case of LTCM is irrelevant because a portfolio option overlay isn’t an options-trading strategy, per se.

One way to distinguish responsible options-based investing from risk bombs is to cite Goldman Sachs Research, which in 2007 wrote that volatility meets the definition of an asset class because:

• Using it can generate significant passive returns.
• These returns can be great enough to “justify a non-trivial allocation.”
• Investments based on it can provide portfolio diversification.

But unlike most—or perhaps all—other asset classes, the opportunities volatility brings are as constant as the water in Rome’s Trevi Fountain, which is believed to have flowed since 19 BC.    

To get clients to dip a cup into this metaphorical fountain, advisors, like psychotherapists, must first help them overcome their fears. In investing, as in life itself, the way to do this is to confront these fears and dismantle their shaky foundations. This can only be accomplished by advisors who have established the requisite trust with clients. Only then will many clients be willing to try something new—something they once mistakenly regarded as overly risky.

Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and Sheaff Brock Investment Advisors. Based in Indianapolis, the firms managed about $1.4 billion as of Nov. 30, 2021.