More advisors have warmed to using options and products that use options in their portfolios in 2018. They have been encouraged by both more volatile markets in stocks and bonds and by the increasing ease and efficiency of applying the strategies.

In October, amid several volatile weeks for U.S. equities, the Options Clearing Corporation cleared a record 567.8 million options contracts, up 48.9% from October 2017’s volume of 381.5 million. According to the Chicago Board Options Exchange (“Cboe,”) October set a new monthly volume record for S&P 500 options, at 41.4 million contracts traded.

The four months with the most total volume of S&P 500 options traded have all occurred in 2018—and some of that growth is occurring via channels beyond high frequency traders and institutional advisors, according to Dave Donnelly, managing director at SpiderRock Advisors. “At the beginning of the summer, we were over $200 million in business,” says Donnelly. “Now we’re over $400 million.”

SpiderRock is a Chicago-based technology-driven asset manager offering customized options strategies to advisors and institutions. The firm saw a 40% jump in AUM over the first half of 2018. According to Donnelly, advisors who use options strategies have prepared for and responded to this year’s volatility with hedging and beta management strategies.

Options As A Differentiator

While options have long been used in the institutional world, and are often used as part of an alternative fund or strategy, they have been underused by advisors so far, according to speakers at this year’s Inside Alternatives and Asset Allocation conference in Las Vegas.

“The ultimate driving force for why advisors don’t use options in scale—or, well, at all—is because options are time consuming,” said panelist Eric Metz, SpiderRock’s president and CIO. “You have a finite amount of time. Using it to articulate to clients what options do might not be the best use of that time.”

It takes time and confidence to get clients comfortable with using options, said conference panelist Eric Cott, director of financial advisor education at the Options Industry Council. For one thing, the nomenclature of options—with Greek letters like “rho,” “theta” and “gamma”—turns off both advisors and retail investors who may benefit from using the strategies.

But in an era where most investment management is considered to be easily replicated, advisors can get a leg up if they can also discuss, access and use options, Cott said. “Options can provide differentiation in an era where advisors need to differentiate themselves,” said Cott. “Even advisors who believe options are not a dominant tactical tool that they’ll use all the time, instead of shying away from learning about options, they would do better to embrace them.”

Options can also give clients tax-management benefits—the premiums lost on expired options can be harvested as capital losses, allowing investors to offset gains taken elsewhere. Using option premiums to conduct the sale of a position can also help offset gains on it, and gains incurred by the sale of options can be offset by the purchase of an equivalent option.

Options Versus Volatility

Volatility increases interest in options for multiple reasons. First, as Donnelly notes, many advisors are using options to hedge positions or an entire portfolio and to manage the beta in their portfolios.

Volatility also makes strategies that write or sell options a better buy for investors, since option premiums increase with volatility, says Doug Kramer, co-head of qualitative and multi-asset class investing at Neuberger Berman.

“Higher premiums gives us more protection and cash flow to withstand these downswings,” says Kramer. “We’re in an interesting moment where the volatility regime appears to have changed somewhat. We’re in an environment where the writing of the options is producing materially higher cash flows than it has in the past.”

Neuberger Berman offers put-writing strategies in both separately managed accounts and in a ’40 Act mutual fund—the Neuberger Berman U.S. Equity Index PutWrite Strategy Fund (NUPIX), which Kramer co-manages. Instead of owning an equity index like the S&P 500 via a mutual fund or an ETF, NUPIX writes put options that give the buyer the right to sell the index at a specified price.

The CBOE S&P 500 PutWrite Index has outperformed the S&P 500 itself with lower volatility over the past 25 years, noted Kramer. In October, when the S&P 500 was down 7%, NUPIX was down 5%.

Mark Esposito, the president of institutional options trader Esposito Securities, says that advisors who embrace options only during volatility are missing the point of using them and the best opportunities for implementing them. Just trying to capture success when the VIX goes up, he says, is “not always a good use of capital,” says Esposito. “That’s an unsophisticated way to put on a trade during a turbulent market.”

Instead, most advisors should implement options between periods of volatility when premiums are lower, he says.

Speaking at the Inside Alternatives conference, Peter Raimondi, founder and CEO of Dakota Wealth Management, agreed. “You want to buy when there’s no volatility,” said Raimondi. “When the VIX is going up and the market is going down, it tells you the market is not on the put side. You want to buy puts when the market is going up.”

Options for Wealth Management

Raimondi, a serial wealth management entrepreneur, has long used options strategies in client portfolios and makes options paperwork part of his firms’ typical on-boarding procedures so that trades and overlays may be applied efficiently when opportunities arise. He’s on the vanguard of a growing movement among individual wealth managers to offer options to their clients.

Donnelly notes that until recently it was options’ cost and complexity that made wealth managers wary of them. “The industry was in a position where strategists had to impose high minimums in order to be successful, but that’s no longer the case,” says Donnelly. “Because advisors were unable to access these strategies for their clients, they stopped looking into them—if they couldn’t really use them, why would they want to learn more about them? And so we’re now in the early stages of the evolution of options for the broader wealth management space.”

Price compression has allowed advisors to use bespoke solutions that hedge large positions in client portfolios, says Donnelly. After a decade-long bull market run, many investors are overconcentrated in U.S. equities, or a handful of technology stocks like the FANGs, but they are psychologically reluctant to sell their positions.

If, meanwhile, fixed income faces a flat yield curve, rising rates and relatively low yields, it may be unattractive risk for the return if investors were to rebalance out of their stock positions to bonds. It would also be tax-inefficient. While some high-net-worth clients may rebalance via an exchange fund that can lock their assets up for a number of years, options strategies can offer more balance between liquidity and tax efficiency.

“Family office clients are sitting on block positions [of stocks] that have had pent-up growth and low basis, so the discussion comes in to see if there’s a way to carve out some of the position to participate in the upside, sell a call to protect on the downside,” said Cott. “Collaring provides the best of both worlds.”

Collaring involves buying a put and selling a call at offsetting prices—at zero cost, since one part of the strategy pays for the other. The put offers a premium to cap potential losses from a position, while the call pays for the downside protection but reduces the potential upside to a stock, resulting in lower potential volatility.

Call writing, selling the right to buy a stock at a specified price, can also be used to manage the volatility exposure of portfolios whose allocations are out of balance without selling the portfolio’s holdings themselves. “Historically, rebalancing has involved selling stocks and buying bonds, but we can bring beta down without having to sell anything to do it,” says Donnelly. “Your assets remain intact, the risk profile is augmented, and no tax bill has been triggered.”

Options for Income

Before the recent increase in volatility, advisors were drawn to options mainly for strategies like covered calls, as bond yields sat at historically low levels for several years, says Barry Martin, a portfolio manager with Shelton Capital Management.

“In the rising interest rate environment, we’ve maintained good numbers in jobs, and Goldman Sachs thinks we’ll get another raise in December” with three or four additional rate hikes next year, says Martin. “Now we’re looking for alternatives for fixed income, so that’s where we see selling covered call options as a good alternative for fixed income through a rising rate environment.”

Shelton offers advisors a suite of income-generating options strategies within separately managed accounts, in addition to equity and fixed-income strategies within mutual funds. Historically, Shelton has raised between 5% and 7% in yearly options premiums, said Martin, on top of whatever cash flows a portfolio’s underlying positions generate.

As interest rates and volatility rise, the higher premiums also make put writing a viable income strategy, says Donnelly. While covered calls are best used with an equity-heavy portfolio, put-writing does best when accompanied with fixed-income investments.

Customize, Or Buy The Fund?

While some institutions and investors may achieve their desired benefits through a fund like NUPIX or a put-writing ETF, Martin argues that it makes more sense to run options strategies in a more bespoke manner in managed accounts.

“We’re able to manage the tax consequences better, especially in meeting the clients’ needs, because selling options generates short-term capital gains,” Martin says. “Some people are looking for those gains; others would like to see them reduced. We’re able to offset some of those large gains with the option premium. We can also sell losers to offset realized gains, but mutual funds and ETFs often don’t have that level of flexibility.”

On the other hand, mutual funds and ETFs offer access to options at low minimums and with less paperwork and overhead. Advisors may have an easier time explaining a strategy contained within a mutual fund or ETF wrapper to their clients, Esposito says—and for compliance-conscious advisors, a prepackaged options solution is probably the best choice.

“You’ve got to have a sophisticated investor if you’re going to put on a bespoke options trade,” Esposito says. “There have been lawsuits and concerns from the SEC about that, and I think it can be a dangerous business. A lot of times, the advisor at an RIA barely understands it.”

While options strategies are becoming more popular, more accessible, less expensive and better understood, compliance concerns remain a serious obstacle to implementing these strategies in client portfolios, Cott told advisors at Inside Alternatives.

“It’s more difficult now for advisors, after the financial crisis and the debate over the DOL rule,” Cott said. “At this point, there’s a very small percentage of the thousands of advisors that are actively using options as an asset allocation tool in their overall portfolio design on a regular basis.”