Investing In Equities While Mitigating Potential Drawdowns With Options And ETFs

Coming into 2020, RIAs and Financial Advisors must continue to help their clients face the same conundrum. The US equity bull market since March 2009 is unprecedentedly long. But the many prognosticators espousing dire predictions have continued to be wrong for quite awhile. The goal, then, is to maintain exposure to US equities while mitigating potential drawdowns. Depending on the age, financial circumstances and risk tolerance level of the client, an additional goal is to produce income, at least some of which can be distributed with minimal tax consequences.

Most published experts seem to agree that we are currently in an unusual environment where these objectives of reducing risk and raising income cannot be addressed by the traditional method of re-allocating some exposure from equities to fixed income. With rates at unprecedentedly low levels, bonds do not satisfy many clients' income requirements. Worse, many bond and asset allocation analysts have opined recently that current bond prices may have more downside risk than stocks because increases toward historic norms would drop the market prices of these bonds considerably. Corporates bear the additional downside of credit risk. The prevailing wisdom I'm reading from the bond analysts to whose newsletters I subscribe is that credit risk in corporate bonds is substantially uncompensated for in the coupon rates. This is because bondholders continue to chase after miniscule differences in yield. means of reducing downside risk and increasing distributable net income. Most of these involve using options.

There are at least a dozen of US ETFs now available that utilize options to implement various strategies to reduce risk relative to 100% long positions. Most also attempt to provide superior dividend yields to the income yields attainable in bonds. The most popular by AUM of these include ETFs with these ticker symbols: QYLD, PBP, HSPX, PUTW, SWAN, ACIO and TCHI. QYLD, PBP, HSPX, and TCHI use buy-write index fund strategies that employ index options: QYLD is based on the Nasdaq-100 index and the other three are based on the S&P 500 index. ACIO also uses a buy-write strategy but the underlying stocks portfolio contains 30 high-yield stocks and also uses protective puts to provide further protection against drawdowns. PUTW and SWAN both write options against US Treasury Bond portfolios but in very different ways, PUTW selling S&P 500 put options while the more conservative SWAN uses long-dated S&P 500 options for its equity exposure.

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Disclosure: I own shares of SWAN, HSPX, and QYLD in my retirement portfolios. I own QQQ and sell NDX options in my investment portfolio.

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