Funds That Use Options Can Offer Protection From the Slide in Stocks

[view original post]

Federal Reserve Chairman Jerome Powell in Washington in January.

Samuel Corum/Bloomberg

Investors may be feeling a bit seasick from this year’s volatile markets. But how can they assuage their queasiness while navigating these rough waters?

John Silvia, who retired as chief economist at Wells Fargo to head Dynamic Economic Strategy, blames those at the helm of the Federal Reserve for the current unpleasantness. The central bank’s policy of reacting to, rather than anticipating, inflation, even when indicators pointed to intensifying price pressures, forced it to tack sharply, he writes in a client note.

He invokes that sailing term to describe the Fed’s shift from a goal of fighting unemployment to curbing inflation. “For investors, this tacking generates market volatility and lacks any hint of the ultimate destination for a policy—as well as adding to seasickness in the financial markets,” he explains.

To extend the sailing metaphor, a better phrase for the Fed’s policy might be an “uncontrolled jibe,” an unintentional shift that causes a dangerous swing of the boom when running downwind. It can result from a sudden wind shift, an inattentive or unskilled sailor, or a combination of factors. Downwind is a trickier point of sailing, so it’s necessary to be especially alert when conditions change. Or in the Fed’s case, prove not to be transitory, as it had thought inflation to be.

With the market roiled by the Fed’s belated inflation response, plus the war in Ukraine and the continued effects of the pandemic, it’s little wonder that stocks are down for the year, while volatility is up. That’s made for higher options premiums, providing investors with more opportunity to earn income by writing, or selling, call options, says David Jilek, chief investment strategist at Gateway Investment Advisers, part of the Natixis Investment Managers group. But 2022 hasn’t seen the sharp, short-term spikes in volatility that pay off for buyers of bearish put options, he adds.

Jilek, who oversees the Gateway Fund (ticker: GTEYX), which uses options strategies to reduce volatility and downside risk without adding the interest-rate risk of bonds, says that investors were fearful coming into the year, bidding up put premiums. So the expense of the puts kept them from effectively protecting holders from the S&P 500’s roughly 15% negative return this year, he says in a telephone interview.

Selling calls against the broad index, he adds, has proved to be a better source for income than bonds, which have declined in price as their yields have increased sharply in 2022.

To tamp down volatility, the $8 billion Gateway Fund juggles index call writing and put buying. The calls are written at or near the money (that is, with strike prices around current levels for the underlying index). That generates the call premium to pay the cost of the put options.

Chatting before Thursday’s late selloff, Jilek commented that stocks had been in a trading range since the mid-May lows, which had damped implied volatility, with the Cboe Volatility Index, or VIX, in the mid-20s range. That was still about one-fourth higher than its long-term average of 19.56, but below the 30 that marks higher volatility.

The lower recent volatility also reduced “skew”—the higher price that puts typically command versus calls, as a result of hedging demand. “Investors who feel like the worst is yet come have an opportunity to get more attractively priced protection,” he says. That would be propitious, given that the buy-the-dip ploy now is less likely to pay off than it had in the past 10 years, when the Fed was pumping liquidity into stocks via quantitative easing, he notes.

Mark J. Grant, chief global strategist at Collier Securities, a unit of Colliers International Group, also utilizes options for his strategies, which are focused on income, income, and income. He aims for 10% annual yields, paid out monthly, and tries to avoid things that will be hurt by the Fed’s interest-rate hikes, notably long-duration bonds.

That points him to a few select closed-end funds. But Grant also uses exchange-traded funds and notes that write options to generate double-digit current income without leverage.

Among the ETFs he likes are Global X Nasdaq-100 Covered Call (QYLD) and Global X Russell 2000 Covered Call (RYLD), which sport annualized yields of 11.82% and 11.83%, respectively, based on Bloomberg data.

And for those looking for even higher income, Grant likes the Credit Suisse X-Links Silver Shares Covered Call exchange-traded note (SLVO), whose payout is 12.47% annually, and the Credit Suisse X-Links Crude Oil Shares Covered Call ETN (USOI), whose payout is an eye-popping 51.79%, as a result of the currently supercharged energy markets, per Bloomberg data. Two caveats: Those payouts can’t be counted on to continue, and the ETNs are obligations of Credit Suisse and so “are subject to our ability to pay our obligations as they come due,” as the bank’s website states.

Options won’t guarantee smooth sailing, but at least they help investors stay in the market, rather than just being moored to cash that still offers next to nothing.

Write to Randall W. Forsyth at randall.forsyth@barrons.com