It’s Always Nice to Have Options (okay, maybe not always)

Given the topic in this week’s Weekly Whiteboard (options), our compliance department has suggested language and concepts that need to be an opening disclaimer.  To that end, please note the following statement as a “disclaimer” before you read below.  I suggest you read this in that really fast-talking voice you here at the end of commercials… it will read better!  First, options are not for everyone, and options trading is not for everyone.  With that said, the following discussion is for informational and educational purposes only and is not intended as investment advice or a recommendation to implement any specific options strategy. Options involve risk and are not suitable for all investors.  Covered call and protective put strategies may limit upside participation, could result in the loss of principal, and may involve tax and liquidity considerations.  Income generated from covered calls is not guaranteed and will vary based on market conditions, volatility, and strike selection.  Any examples provided are illustrative only and do not reflect actual client performance.  With that out of the way… enjoy your reading!

There are many types of assets and allocations in the investor tool kit.  The job of the investment manager is to allocate the portfolio in a way that matches a client’s goals, risk tolerance, risk capacity, time horizon and return expectations.  To that end, most investment managers use a variety of assets, asset classes, and asset type to create a portfolio.  And, while equities may consume the bulk of a portfolio’s risk, they (historically) have provided a meaningful amount of a long-term portfolio’s return.  So, how do we determine what goes along with those equities?  Well, it depends on your goals.  In fact, having equity exposure at all depends on your goals as well, but most goals require some level of equity risk so let’s focus on other assets used to achieve goals.  We are going to exclude private (non-traded) investments for the purpose of this post so let’s go to the next most common asset: bonds.  Bonds (specifically investment-grade) can dampen volatility in a portfolio and provide income in the form of interest.  We can also invest in commodities (although for purposes of an investment account allocation, those need to be in the form of a fund), we can invest in preferred stocks (a combination of equity exposure and interest payments), and we can invest – through ETFs and mutual funds – in other asset types like private credit, real estate, etc.  There is another asset we can invest in to help achieve our goals… any guesses?  YES, options!  I had you on the edge of your seat briefly I know.

Why Options Deserve a Seat at the Asset Allocation Table

Once relegated to the shadows of financial markets — whispered about in hushed tones by day traders and esoteric hedge fund managers — options have stepped out of the side tent and into the main ring of long-term portfolio strategy.  What was once considered a high-risk, short-term speculation tool is now being re-evaluated as a potential mechanism for enhancing returns, managing risk, and introducing flexibility into asset allocation.  Welcome to the modern era of portfolio management where puts and calls are not only respectable but strategic.

The Misunderstood Derivative

Let’s get something straight: options are derivatives — yes — but calling them mere “side bets” on stock prices is like calling a seatbelt an accessory in a car.  It misses the point entirely.  An option is a financial instrument that derives its value from an underlying asset (typically a stock or ETF).  But in practical terms, it is a highly flexible contract that gives investors — both institutional and individual — a menu of choices for adjusting exposure, capturing income, and building resilience into portfolios.  We (East Franklin Capital) have, for over a decade,experience implementing options strategies where appropriate based on clients’ risk tolerances and goals.  For some investors, options may serve as a complementary tool within a broader portfolio strategy.  The critical takeaway: options are no longer peripheral.  In fact, for the long-term investor, they really might (should?) deserve a seat at the table.

The Option Income Toolkit

In a world where dividend yields are modest and bond yields are uneven (and currently low), investors are hungry for alternative sources of consistent income.  Call options give the holder the right, but not the obligation, to buy an asset at a predetermined price before a specified expiration date.  While traditionally associated with speculative bets on rising stock prices, call options can serve a far more strategic role in a long-term allocation.  One important note: for this piece, we are primarily talking about covered call options, meaning, we own the underlying ETF or stock from which the option is derived, and the call options is simply trading away potential future appreciation for income today.  In fact, we are actually selling the call options – and, not only selling, but selling to the investor looking to speculate on the movement of the underlying security during a particular period of time.  To that end, selling call options (if/when used strategically) can transform a static portfolio into a more dynamic income producer.  To be clear, this comes at a trade off as income is typically generated from selling a portion of the upside of the underlying holding.  But, if the goal is income and other portions of the overall asset allocation are long the market, that can be a great trade off to make.  Below are a few options for options (yeah, I had to do that at some point!)

Covered Calls: Monetizing Ownership
If you own 100 shares of a stock or ETF, you can sell (write) a call option against that position and collect a premium.  If the stock rises above the strike price, you may be called away — but at a gain (a gain that is taxable if not in an IRA or tax deferred account).  If the shares don’t get called away, you simply keep the premium and repeat the process.  Think of it as a rental income strategy — but instead of renting out a property, you’re renting out part of maybe all of the upside potential on a stock or a fund.  Over time, this can smooth returns and reduce portfolio volatility.  To be clear, you still own the underlying shares and participate if the stock/fund declines – but that premium has already been collected and generated positive return during that decline.  Now, keep in mind (as I am sure the options skeptics will chime in), if that stock moves up substantially, you will get called away and NOT participate if there is substantial upside.  That is correct, however, as I often say to skeptics/clients/the guy next to me on a plane/my dog… but we do not hold these particular positions for the upside if they are in this strategy, so we are not losing the upside… just trading it for call premium income.

Advanced Touch: Rolling and Laddering
Another feature of covered call strategies is that they are liquid and can be managed actively — rolling up, out, or down based on market trends and volatility.  Laddering expiration dates or mixing strike prices adds nuance, allowing income capture across market conditions.  This is where your investment advisor (the investment manager in our case) can provide significant value.

Bonus Benefit: Volatility Harvesting
Option premiums rise with volatility.  When markets get jittery, income potential increases — a feature not necessarily found in other yield strategies.  In certain market environments, options premiums may increase during periods of higher volatility – a potential win at a time when other investments might be losing.  Of course, like any investment, options strategies can still experience losses – but a smaller loss (as compared to other investments) can feel very much like a win.

Put Options: Insurance That Works When It Counts

Okay, I will say/disclaim up front that I am not giving this section nearly its due in terms of description or explanation… but there is only so much detail I can cram into these posts.  Defensive put options (the write to sell a stock or fund at a specific price by a certain date) can be somewhat complex and a covered call strategy is really the focus of this piece.  However, puts can be an effective (if efficient) way to shift risk or dampen volatility in a portfolio.  Put options are often described as “insurance,” but let’s unpack that metaphor more carefully.  Like all insurance, the goal is not to make money from the policy itself — the goal is peace of mind, portfolio longevity, and damage control when the negative event happens.  Put options may help reduce downside exposure, although they involve costs and may expire without value… like you hope your home insurance does each year.  One note – puts are NOT the same as “shorting”.  Puts have a finite potential for loss where a short can have a limitless potential for loss.

Use Case 1: Hedging Tail Risk
Let’s say you’re holding a broad market ETF as a long-term core position. You’re bullish long-term but wary about an upcoming election, central bank meeting, or geopolitical shock.  Buying a long-dated put on the index gives you a downside buffer — think of it as your financial airbag.  You hope never to need it.  But when the market hits a pothole the size of 2008 or 2020, you’ll be glad it deployed.

Use Case 2: Sector or Single-Stock Exposure
Investors often face concentrated positions due to stock-based compensation, legacy holdings, or strong convictions. A long put on a concentrated holding can prevent a drawdown from becoming bigger loss — especially when selling the position is off the table due to tax consequences or internal restrictions.

Use Case 3: Behavioral Risk Management (maybe my “favorite” of uses)
Options can serve as an antidote to panic.  In volatile markets, the knowledge that a defined floor exists beneath a portion of your portfolio can prevent emotionally driven decisions.  This makes puts not just financial insurance — but psychological insurance.  And in a long-term strategy, that may be worth its weight in premiums.

Integrating Options into Asset Allocation

Even with the disclaimer that it is true that options are not for all clients or all portfolios, at East Franklin Capital, we see options not as tactical one-offs, but as a potentially integral building blocks of long-term portfolio construction.  The evolution of the options market — in both liquidity and accessibility — makes it more viable than ever to include options strategies in client portfolios, whether in taxable accounts, IRAs, or trusts.

A Word on Complexity

Yes, options introduce some complexity – or, at least, another moving part.  But, that is why you engage an investment professional!  Today’s diversified portfolios often include real estate, private equity/credit, and more acronyms than a government agency.  The irony?  A properly managed options strategy may be less risky than a concentrated position in a single asset class.  Investment options are many and markets are strange.  Your strategy doesn’t have to be.

Conclusion: The Case for Options, Reconsidered

It’s time to retire the myth that options are solely for gamblers and market timers.  In fact, that really couldn’t d be farther from the truth.  They are traded investment assets and, as such, have risks and rewards, benefits and detriments.  However, when used responsibly and deliberately, options offer some of the most powerful tools in modern portfolio management.

• They can hedge.
• They can generate income.
• They can unlock capital efficiency.
• They can introduce intelligent flexibility.

In short, options — both calls and puts — aren’t peripheral.  If the risk profile, investment goals, and investment experience check the right boxes, options could be a great tool in your portfolio’s toolbox.  And in a market where uncertainty is the only certainty, they may be exactly what long-term investors need.

If you would like to discuss whether options strategies may be appropriate for your financial plan, please contact us.  East Franklin Capital offers custom portfolio overlays and options-based income strategies aligned with disciplined financial planning.