Many investors seeking to reduce volatility in their portfolios are employing "options strategies" to soften the potential drag on growth caused by market volatility. I recently spoke with Brett Carson, director of research at Carson Wealth Management, about options.
Carson crafts analyses of companies to identify undervalued stocks that carry attractive upside potential. He has more than a decade of experience conducting deep, fundamental research on small- to mid-cap companies for mutual and hedge fund clients.
CNBC: Can you explain what options are and what role they play when an advisor uses them as part of an investment strategy?
Brett Carson: Options are contracts, giving a buyer the right, but not the obligation, to buy or sell a predetermined number of shares at a specific price within a specific period of time. Options are derivatives, meaning their worth is determined by the value of an underlying investment.
Options can play many roles within investment strategies. They can be used to hedge against market volatility, while they can also be used to leverage assets to magnify gains or losses.
CNBC: What are the pros/cons of using an options strategy?
Carson: Pros: Options allow an advisor to increase or decrease their exposure to certain investments without buying or selling shares of a holding. It can provide a great deal of convenience for an advisor.
Cons: Options are highly complex financial instruments. Unless an advisor has experience dealing with these highly volatile investments, you can quickly get yourself into trouble by miscalculating the amount of exposure you seek.
CNBC: What are the benefits of using managed options strategies for clients?
Carson: In reference to managed futures strategies, I would question the value these strategies provide. Again, you must fully understand options strategies before using them. Simply taking a manager's word that their strategy will reduce volatility in your portfolio isn't good enough.
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Many of the managed futures strategies that have grown popular are very expensive for the minimal amount of value they ultimately provide. Verifying and analyzing the total fee structure of any managed strategy is vital.
Also, understanding exactly what's going on inside a managed strategy is essential. If something seems overly complex and an advisor is unable to effectively translate how a strategy operates, they shouldn't put their client's assets, and their reputation, at stake.
CNBC: How do you use covered call options, index options and option overlay strategies for clients?
Carson: Options should be used in a very transparent and straightforward fashion. First of all, we will use put options to limit downside exposure in our "Irreplaceable Capital" strategies. We emphasize that for many clients, protecting your downside is their No. 1 priority.
Asset allocation simply didn't work in 2008–09, and we shouldn't expect it to work again when the next financial crisis occurs. We believe that in this "new era" of investing, options are a viable option to reduce volatility.
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We also have a covered call strategy that we call "Write Income." With interest rates at record lows and traditional fixed-income investments seeming more risky than ever before, we have been forced to become creative when it comes to generating yield for our income-hungry clients.
In response, we came up with Write Income, a strategy that buys high dividend–paying stocks and sells covered call options on our holdings. We have been very pleased with the results and expect it to remain a viable alternative to overstretched and low-yielding traditional fixed-income options.
CNBC: Can you explain using index options strategies for investors who already have a diversified portfolio?
Carson: Diversified portfolios can't guarantee your assets won't uniformly lose value in another downturn. We would love to use simplistic asset-allocation strategies, but we don't feel that those are appropriate any longer.
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In 2008–09, there was a lengthy period of time when all asset classes declined in unison. We feel much more confident when we own investments that work quite literally as an insurance policy on our investments.
If the markets experience another rough patch, we know that as long as the options market remains liquid (and if that doesn't happen, we have some much larger problems), we will manage volatility in our client's portfolio. Asset allocation can't provide that level of security.
CNBC: When does it make sense to apply an absolute return investment strategy?
Carson: We feel that clients should utilize our Irreplaceable Capital strategies when they're sensitive to volatility due to either their place in their life or their unwillingness to watch their investment portfolios fluctuate.
Also, in almost all cases, we utilize our absolute return strategies to balance out the overall risk of a client. Unless a client has a high risk tolerance, the chances are, we will have at least a portion of their portfolios invested in an absolute return investment strategy. We subscribe to the mantra, "If you protect the downside, the upside will take care of itself."