Written by: Joanne M. Hill, PhD ., Chief Advisor for Research and Strategy at CBOE Vest
Just like homes can be remodeled to meet the evolving needs of homeowners, Investment portfolios can also be “remodeled” to better match investment goals such as higher income, growth or lower risk.
Options are among the best portfolio remodeling tools; they can be utilized to achieve a target level of income and risk without disturbing other parts of the portfolio. Options allow an investor to buy (call) or sell (put) a security at a predetermined price (strike price) on or before a specific date (exercise date).
Covered-call writing is a popular strategy that involves selling call options on stocks in exchange for receiving upfront premiums. It gives stock owners the ability to convert uncertain future upside returns into upfront premium income and reduces risk, as the premium income helps cushion downside returns.
Remodeling the S&P 500 Aristocrats Index to Target Income
Remodeling with options can be incorporated into equity index strategies through a rules-based approach similar to that which is used in smart beta or factor strategies. Such remodeling can solve the dilemma faced by equity income investors, helping them both satisfy their need for income and achieve growth from capital appreciation. Until recently, these investors have had to choose between higher dividends, higher volatility and lower total return from high-yielding stocks (such as the S&P 500 High Dividend Index) and lower income, lower volatility and higher total return from dividend growers (such as the S&P 500 Dividend Aristocrats Index), as shown below.
11.95%Volatility (10-year annualized)18.39%14.09%
Source: S&P Dow Jones (As of April 30, 2018)
But now, an innovative options remodeling strategy, built upon a higher quality basket of stocks, provides an opportunity for both higher income and higher total return.
Consider the Cboe S&P 500® Dividend Aristocrats Target Income Index (Ticker: SPAI) and the Cboe S&P 500 Dividend Aristocrats Target Income Index Monthly Series (Ticker: SPATI). These indexes are “remodeled” versions of the long-standing S&P 500 Dividend Aristocrats Index (SPDAUDP), which selects stocks from the S&P 500 that have a 25-year track record of consecutive dividend growth. SPAI and SPATI vary from the original S&P 500 Dividend Aristocrats Index in that they incorporate the selling of call options on a small portion (typically 5% to 15%) of each stock position to convert a portion of the stocks' potential upside returns into income. The goal of the SPAI and SPATI strategies is to generate income from option premia that, along with stock dividends, produces annual income that is 3.5% (SPAI) and 3.0% (SPATI) over the dividend yield of the S&P 500.
Abundant Design Options Available
Many design alternatives are available for portfolio remodeling using options. Investors can select how frequently they want to receive the premium income, how much of their portfolio to involve in the strategy, and how much of the potential upside returns they want to shift into upfront premium income. By using options with either one week or one month to expiration, with strike prices “at the money,” the SPAI and SPATI indexes apply the covered-call strategy on a small portion of the portfolio with a large impact on income. The portion of the portfolio overwritten is determined by the target annual income level relative to the size of option premiums. In periods of higher volatility, a smaller portion of the portfolio is overwritten as option premium levels are higher, while in quieter markets with lower volatility, the portion of the portfolio covered is larger.
A well designed and executed remodeling project can improve the value or appeal of your home. In a similar manner, investors can use options strategies to modify an equity portfolio to better meet their income or risk goals. These strategies can be implemented with the help of a financial advisor or can be found packaged in smart beta indexes like the Cboe S&P 500 Dividend Aristocrats Target Income Index (SPAI) and the monthly series of this index, SPATI. These indexes look to alter a popular dividend-growth strategy into one that has a higher portion of returns from income, a feature that was previously only available by investing in equities with high dividend yields. By using options as a remodeling tool on a variable portion of the underlying stock exposure capped at 20%, investors can achieve higher income without taking on the sector, style or factor tilts found in high dividend yield indexes. They can also avoid some of the lower quality stocks that pay a high dividend yield because of recent stock price declines. The result is to enhance the portfolio income component while still maintaining a favorable total return/risk profile vs. the S&P 500.
For more information on these strategies, see these videos by S&P Dow Jones Indices: Targeting Income and Protection with Dividend Aristocrats and Implementing Dividend Aristocrats with Covered Call Writing .