Strategies: How to deal with increasing volatility

The VIX measures the implied volatility for S&P 500 composite index options. A higher value for the VIX means higher options premiums. And as premiums rise, financial advisors might consider options-writing strategies – notably, covered calls or cash-secured puts.

There are several advantages to a covered-call strategy. For one, it’s easy to explain because it’s about generating tax-advantaged cash flow during a period of uncertainty.

More to the point, a covered call fosters discipline during periods of heightened volatility, which is in short supply. In such times, clients may experience an emotional roller-coaster during which they recognize danger but are unable to react – much like a deer caught in the headlights.

Writing covered calls is a strategy that can bridge that gap. The concept is simple enough: suggest that your client write a call at a strike price above the underlying stock’s current price. Your client is comforted in the knowledge that you have a strategy to deal with market uncertainty – which does not require the client to execute a sale of his or her stock immediately at a time when the market is undergoing a correction.

From the advisors’ perspective covered-call writing adds value relative to buy and hold, which is the equivalent of doing nothing. When you think about it, covered calls win in three out of four scenarios.

As the premium from a covered call reduces the stock’s adjusted cost base, your client loses less if the market continues to decline. If the market flattens and volatility drops, the cash flow from the sale of the call adds value, which beats buy and hold. Finally, if the underlying stock settles near the strike price of the call at expiration of the call, the strategy beats buy and hold.

Only if the underlying stock rises dramatically does the covered-call strategy underperform. At that point, your client loses any potential upside above the strike price. But even in that scenario, you can point to the fact that the covered-call strategy earned its maximum profit. That’s not a bad thing in a high-risk environment.

The other options-writing strategy that you could put on the table is selling cash-secured puts. The challenge is this strategy probably is suitable only for more sophisticated clients. It’s harder to explain and its use is limited, as cash-secured puts are categorized as a Level 4 options strategy – and many sponsoring firms do not allow brokers to execute Level 4 options strategies.

That said, cash-secured puts are an interesting strategy if your client has been holding cash in anticipation of a correction. In that light, the sale of an uncovered put obligates the client to buy shares of the underlying stock at a specific price for a limited period of time. Think of it as a “limit order,” in which the client earns a fee ( the option premium) for his or her commitment.

The key with any sophisticated strategy is to remove leverage from the equation. If, for example, your client is interested in buying National Bank of Canada’s stock, which was recently priced at $51.60 a share, you might look at selling January 50 puts at, say, $1. If you sell five puts, your client would secure the position by having $25,000 (equivalent to 500 shares of National Bank at $50 each) in cash available to buy the shares should the puts be assigned.

Given that the profit and loss metrics of cash-secured puts mirror those of a covered call, the puts leave your client in a better position if the underlying stock rises, stays the same or declines.

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