Options and Volatility Strategies -- Describing Liquid Alts
Some equity funds may add option hedges in an effort to dampen portfolio volatility, generate alpha, and reduce tail risk. Option hedges provide a vehicle for potential alpha, allowing tactical managers to express multi-dimensional views on security price, volatility, and time. Systematic option strategies—which include covered-call, collar, put-writing, and more-complicated strategies—allow managers to potentially exploit the nonlinear characteristics of option payoffs to shape the return distribution.
Selling options generally allows for capture of volatility risk premia, which like the equity risk premium tend to capture positive returns over time, albeit with some level of volatility and risk.
It is our belief that buying options can function as a form of insurance, offering the ability to hedge against large market moves in either direction. The combination of buying and selling options on different securities, expiration dates, and strikes allows for a wide range of possible return profiles. Advisors should seek guidance from fund managers as to the level of upside and downside participation targeted by the manager. We believe these products can be useful in producing various risk/return distributions that can be tailored to individual circumstances and risk tolerances.
Beyond traditional index options strategies, several funds are now deploying single-name equity-options strategies. In addition, a number of mutual funds provide investment exposure to volatility-based futures contracts and exchange-traded notes that are tied directly or indirectly to the CBOE VIX and similar indexes. These volatility-futures funds differ from options-based long/short equity strategies in that volatility is considered to be an entirely separate asset class managed without integrated positions in the underlying securities. Some of these strategies maintain systematic long exposure to the volatility indexes to hedge against unforeseen disaster in the equity market. Others maintain systematic short exposures to try to capture the volatility risk premium and benefit from periods of contango—where the futures price is higher than the expected spot price—in the VIX futures curve. It is important to note that the spot VIX index is not directly tradable and the VIX implied-volatility index is not a storable commodity. Traditional cash-and-carry arbitrage pricing rules that apply to futures on physical commodity goods are therefore irrelevant to pricing or even understanding the VIX futures forward-curve. The VIX futures market is a useful tool in many situations, but any investor considering volatility-future strategies from a wealth-management standpoint should take the extra effort to research the subject and ensure that the fund chosen truly provides the intended exposure or hedge.
Any options strategy deployed in a ’40 Act fund must comply with the related limitations on leverage, shorting, and derivatives. These constraints may hinder some lower volatility strategies with high risk-adjusted returns from being easily offered within a mutual fund in a levered, higher volatility format. This may rule out the use of the use of some defensive options strategies for certain investors with very high risk tolerances.
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The information contained herein is derived from sources believed to be accurate but is not guaranteed. It is not intended as tax or legal advice and it may not be relied on for the purposes of tax avoidance. The reader is encouraged to seek tax and/or legal advice from an independent professional advisor. Neither the information presented nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any security. This information was written and prepared by Larkin Point Investment Advisors LLC. All rights protected.
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