STAR™ III – Managed Option Strategies

The goal is regular income with decreased exposure to market risk. We work to achieve our goals by structuring a targeted outcome. Option based strategies developed by Partnervest utilize covered calls, or a combination of covered calls and puts and can be implemented on a basket of ETF’s or concentrated stock positions.

Why ETFs?

Exchange Traded Funds (ETFs) are often described as a cross between index mutual funds and individual stocks. Like index funds, ETFs represent diversified portfolios of securities that track specific indexes. Like stocks they can be bought or sold throughout the day on an exchange. The growth of ETFs has been phenomenal. The first ETF was introduced in 1993 and today there are close to 1,000, with assets in ETFs approaching the trillion dollar level. Their popularity is understandable; ETFs provide four important advantages over traditional mutual funds:

  • More Transparency. Investors know on a daily basis what is held in each ETF, unlike actively managed mutual funds.
  • Greater Flexibility. ETFs can be traded throughout the day on the exchange, unlike funds that are priced at the close of the market.
  • Usually Lower Expense Ratios. ETF expense rations are typically 0.25% to 0.75%, in some cases less than half that of mutual funds.
  • Option Opportunities. Options can be bought or sold on ETFs since they trade like securities, but are not available on funds.

Why Options?

Covered call writing, selling options on securities an investor owns, is an accepted way to generate income among individual investors. A call option gives the buyer the right to buy the underlying security at a specific price (called the strike price) on or before the option’s expiration date. In return the buyer pays the writer a premium.

Writing covered calls on a consistent basis can produce a reliable stream of income and help offset a drop in value in the security. If the price of the security rises however, and the buyer executes the call, the investor will lose any additional appreciation the security may have had.

Options also offer several ways to manage investment risk. One way to protect a portfolio from a drop in price is by purchasing a put. If the purchaser is holding shares of the underlying stock it is known as a protective put.

Puts give an investor the right to sell a security at the strike price, no matter how low the market price drops, before expiration. With the cost of the option’s premium, the investor has been insured against a loss in stock price.

Alternatively an investor may want downside protection, but to also allow for price appreciation. Under this scenario an investor could implement a call spread. In this option position a call is purchased while another call on the same security is sold. The two calls may have different strike prices, different expiration dates, or both.

Why Manage Volatility?

Option premiums are one of the key ways income is generated for the Partnervest portfolios and one of the greatest factors affecting the price of the premiums is volatility. Generally, the greater the volatility, the higher the option premium. The most widely used measure of volatility is The Chicago Board Options Exchange (CBOE) Volatility Index (VIX), a key gauge of market expectations of volatility over the next 30 days. To measure it they use Standard and Poor’s (S&P) stock index option prices.

Volatility-in-Action-Chart

Source of Returns: Bloomberg