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Equity Risk Management

With the expertise of our Options Strategist and the high quality of our electronic trading platform, our clients have consistently benefited from quality ideas and executions. When used properly, option strategies have the potential to help clients enhance portfolio returns and to protect portfolio gains. BB&T Scott & Stringfellow offers our clients the ability to trade nearly any domestic option contracts and to implement almost any available strategy; we focus the majority of our attention on the most conservative option strategies that offer our clients the ability to manage risk in their portfolios over the long-term. These strategies may include:

  • Covered Call Writing
  • Protective Put Purchase
  • Equity Collar (a combination of a covered call and a protective put purchase)

The use of equity options has grown since they were first introduced in the 1970s. At BB&T Scott & Stringfellow, our Financial Advisors are increasingly utilizing covered calls as a tool to manage risk and generate income in client's equity portfolios. For example, by selling a covered call against an equity position, an investor gives another investor the right, but not the obligation, to buy their stock at a specific price (the strike price) up until a specific date in the future (the expiration date). In return for giving someone else this right, the seller of the call collects a cash premium upfront. A protective put gives the investor the right, but not the obligation to sell their stock at a specific price (the strike price) up until a specified date in the future (the expiration date). In return for acquiring this right, the protective put purchaser pays a premium up-front. If the put expires worthless, the holder may lose all of their original cost in acquiring the put (including commissions). Additionally, the investor still realizes market risk down to the strike price of the put. An equity collar simply combines the purchase of a protective put with the sale of a covered call to give the client the peace of mind of establishing a pre-defined range within which the value of their combined position can fluctuate. Multi-leg option strategies can be subject to multiple transaction costs (e.g. commissions, fees, other charges).

We can look to a hypothetical real estate scenario to draw a simple analogy to covered call writing. Suppose an individual is looking to sell a piece of property with a current market value of $175,000 for no less than $200,000. Suppose another investor feels that the market value of this same property is going to appreciate significantly above $200,000 over the next six months. This investor is willing to pay the owner $5,000 today for the right, but not the obligation, to buy the property for $200,000 at any point over the next sixth months. The investor collecting the $5,000 keeps this payment regardless of whether or not the property is sold for $200,000. Covered calls function in the same way. The seller of a call settles for a limited amount of appreciation in exchange for a cash premium up-front. While a covered call strategy may not be suitable for outright bullish investors who may be averse to limiting their potential appreciation in an equity position, it may be attractive to neutral to moderately bullish investors who desire:

  • Limited protection against downside movements in their equity holdings
  • Additional income for a portfolio of equities
  • The potential for reduced exposure to volatility in a portfolio of equities

The income generated from selling covered calls provides limited downside protection for the underlying equity position and may reduce the volatility of that position. Should the underlying stock fall to zero, an investor's downside exposure to their underlying stock position has been reduced by the amount of cash received from the sale of the covered call (reduced by any applicable transaction costs such as commissions or fees). The trade-off is that the investor limits their potential appreciation in the underlying stock up to the strike price of this call option. Again, this may not be an attractive alternative for very bullish investors, as they could be precluded from benefiting from a significant rise in the underlying stock. When evaluating any investment strategy, it is very important to identify its place on the risk spectrum. Selling covered calls can be more conservative strategy than simply owning the underlying equity in that the premium received for selling covered calls can assist in hedging against downside movements in the underlying stock price.

In summary, covered call writing can be an effective means of generating extra cash flow and reducing downside exposure and volatility within a portfolio of equities, while still allowing for reasonable but limited growth of capital.