Options are a great way to add diversification and an alternative income
stream to your portfolio, but the strategy can often be confusing for
some investors. Between calls, puts and strikes, it’s easy to get lost
in the terminology.
Frank Maeba is one of the portfolio managers at Neuberger Berman Breton
Hill ULC who runs Purpose Premium Yield Fund (PYF) and Purpose Enhanced
Premium Yield Fund (PAYF). The portfolios use a specific options
strategy known as cash-covered put writing where puts are sold to other
investors to earn a premium. We spoke to Frank about how the strategy
works and why it’s a powerful tool every investor should consider.
First off, what’s the difference between selling calls and selling puts?
When you sell a call, someone on the other side of the options contract has the right to buy stock from you at a higher price. When you’re selling a put, the person who owns that put has the right to sell stock to you at a lower price. That’s the main difference. Selling a put means you could end up buying stock. As a seller of calls, I could end up being short stock.
How can investors use puts in their portfolios?
Probably the number one way to use a put as an investor is really to protect your portfolio from going down. If you’re long equities or long certain stock names and you’re worried that there are bad things happening in the world or that the market is topping out, and you want to protect against that kind of downside, you can pay a premium – basically a type of insurance that protects you against that stock decline. So, you’ll have the right to sell that stock at a pre-defined level, even if it’s trading significantly lower.
How exactly does a put act as insurance for your stocks?
There are two sides of puts. Investors who are worried about a downward move generally will pay up for insurance to protect their portfolio [by giving them the right to sell stocks at a certain price even if they decline]. On the flip side, there are people who sell that insurance and they try to collect those premiums. They try to collect as many premiums as possible because over a long cycle in general, collecting premiums is a pretty healthy business.
Once every year or every couple of months, you might get impacted by a bad event where you have to pay out on that insurance claim, so to speak. Over a longer cycle, there are many businesses predicated on collecting those insurance premiums. The way we set up our own current portfolios in PYF and PAYF is similar to that. We’re selling insurance or put premiums, collecting those premiums and generating a healthy yield. And hopefully we can risk manage the portfolio so we don’t really have a bad event happen across the portfolio.
Is selling puts essentially applying the insurance business model to an investment portfolio?
That’s exactly it! You’re picking up small premiums. Think of it as earning maybe a dollar a month selling puts. Hopefully you can string together a lot of positive months where you collect a dollar every month for 11 months, and then on the final month something bad might happen. You’ve collected hopefully 11 dollars in premiums, and then you might actually have to pay out half of it to cover some bad event. But net-net over the course of the year, you get to keep more than you pay out. And that’s the gist of this strategy and of the insurance business.
Insurance companies sometimes pay out huge amounts, yet they manage to operate in a fairly stable manner. Does selling puts add stability to your portfolio?
It’s a pretty consistent way of generating an income in yield that’s pretty diversified versus just owning dividend equities or fixed-income credit. It gives a very different risk profile that can be stable over time. When you’re dealing with options there can be two key things that help make it more of a steady ride.
First of all, it’s experience. At Neuberger, we’ve had a lot of experience managing these types of option portfolios going back decades. There are certain things you can do to help manage the risks of this kind of strategy so that when it does draw down and you have to pay out that insurance, maybe it’s not as deep a payout as you might expect.
The second thing for managing risk is just doing it consistently over time, diversifying the names of the portfolio and trying not to use too much leverage. PYF and PAYF are unlevered strategies. These are the kinds of things that help minimize the risks of a big blow up.
What exactly are you looking for when you decide to execute an options trade?
First and foremost, it’s not really the derivative we’re looking at, especially in PYF and PAYF. We start off with “are these stocks that we want to ultimately own?” The way to think about a lot of this strategy is you sell a put, you earn a premium. If you happen to get put to, meaning the option is exercised and you end up owning that stock, that’s not necessarily a bad thing. Another way to think about it is that you’re earning a premium while waiting to potentially own that stock at a lower price.
We start off our analysis by saying “what’s a good group of stocks that have good value characteristics, good quality characteristics, good positive cash flows, et cetera that we would love to own just outright, but also would love to own on a dip if they pull back 5% or 10%?”
Once we identify that group of stocks, we do a secondary screen where we look at “do these have attractive volatility or option characterizes that we think are worth writing puts on?” The things in the secondary part of that process would be “do they exhibit high volatility?” That usually means they pay a higher premium, so you get to harvest that higher premium on that name.
Probably the biggest thing in running this type of program is that the names have to be highly liquid. We tend to really only write puts in the US market because it has the deepest options liquidity. And you want that kind of liquidity to manage the underlying instruments.