Guest Author: Rob Emrich III, Founder, Managing Partner, Acruence Capital

Make no mistake about it: option income is here to stay. The proliferation of option strategies to generate income (risk premia) and the growth of Exchange-Traded Funds (ETFs) have been remarkable in the last five years with AUM growing from approximately $2 billion in 2019 to over $77.7 billion as of March 28, 2024 (see chart 1). ETFs are highly attractive vehicles for option strategies for various reasons, including tax efficiency, exchange listings for easy purchase and daily transparency.

Chart 1

Source: Cboe Global Markets

Undoubtedly, the landscape of investment income is undergoing a transformation that is both dynamic and enduring. The integration of option strategies as a means to generate income has seen a significant surge in the last five years, marking a particularly notable expansion. Exchange-Traded Funds (ETFs), in this context, stand out as highly appealing instruments for implementing these option strategies. Their allure can be attributed to a host of advantages: they offer tax efficiency, are readily available on exchanges for convenient trading and boast a high degree of transparency. We have found that high net worth individuals, particularly those with a liquid net worth exceeding $5 million, often opt for separately managed accounts.

This article will discuss several reasons for this preference, including customization and the ability to use leverage. We'll also discuss the favorable tax treatment of the preferred contracts, and some lesser-known tax benefits, of which many advisors and even CPAs may not be aware.

Most put-write strategies in the marketplace share common features: a fixed tenor, a fixed strike distance, and the potential for significant drawdowns, as the sold puts are typically uncapped. Using these strategies within a separately managed account allows for extensive customization. However, we advise exercising caution, as excessive complexity can adversely affect the strategy's resilience and consistency. We have identified several areas where customization can enhance robustness.

Distance of Sold Put from Spot

One approach is to dynamically adjust the sold put's distance from the current spot price (percent out-of-the-money). Unlike the Cboe PutWrite Index, which always writes put options at the money; varying the distance based on volatility or variance parameters provides a cushion. This adjustment produces a buffer zone which allows some market downturn without immediately affecting capital. However, there is a trade-off: while it may better preserve capital, it could result in lower premiums, as the distance from spot increases, premiums tend to decrease (see chart 2). This strategy can also potentially reduce variability and drawdowns, which could improve client retention by encouraging continued investment and potentially lead to better outcomes.

Chart 2

Source: Bloomberg Professional and WallachBeth Capital LLC

Customization

Use a Put-Spread

Use of a put spread can significantly reduce downside exposure. Instead of selling a single leg (put) and exposing the client to undefined loss, a put spread with a clearly defined maximum loss, tailored to the client's risk tolerance, is often more attractive to investors. It allows them to remain invested with reduced risk, although it typically generates slightly lower income due to the cost of the purchased put that serves to cap the downside.

Sell Puts Within a Desired Income Range

This parameter can have the benefit of reducing risk. A hypothetical example: In a low volatility regime (VIX < 15), put options may be sold closer to spot, 1% OTM (out-of-the-money), to achieve, say, a 7% annualized income target (risk premia). If volatility spikes (VIX > 25) it may be possible to sell the put 10% OTM and still achieve the 7% annualized income target and reduce the probability of the sold put expiring ITM (in-the-money). This approach helps clients understand the associated risks: a strategy aiming for a 20% option premium inherently carries more risk than one aiming for 5%. While income targets offer no guarantees, they guide investors on the potential risk involved in option placements. The goal is to clearly communicate risk, not to promote the "income". Be mindful of industry regulations that prevent targeting specific returns.

Add an On/Off Switch

Based on our experience with put selling strategies during periods of high volatility (such as those in 2008 and 2020), we have observed that some clients prefer to move to cash which has significant implications for reentry. Consequently, it may be beneficial to devise a signal within your strategy that either diminishes exposure or deactivates the strategy entirely during times of increased volatility. While it is recognized that some of the richest premiums can be found during these tumultuous periods, such volatility may not be suitable for all investors. Implementing an on/off switch could effectively alleviate their concerns.

Staggered Strikes and Tenor

Staggering the strikes when selling put options can diminish the probability of those options expiring in the money. For instance, instead of selling the entire strategy's options 2% out of the money, one could distribute the strikes more diversely—1%, 2%, and 3% out of the money—allocating approximately 33% of the capital evenly across these strikes. This approach might be more appealing to certain investors who are prone to fixating on a single strike price each month, and it could also alleviate client anxiety at the time of option expiration. Moreover, the integration of staggered expirations may contribute to a reduction in client stress and aid in moderating volatility. For example, clients might opt for an assortment of expiration periods, such as 2, 3, and 4 weeks, or 30, 60, and 90 days, as opposed to adhering to the conventional "30-day standard." However, the trade-off for employing staggered strikes and expirations may make it more challenging to understand for both clients and advisors.

Add a "Grace Period"

Allow a few trading days for expiration before a new option is required to be placed. For instance, the Cboe PutWrite Index typically writes puts the next immediate trading session after expiry. This can be problematic when there is a binary event with the potential to significantly move the markets. For example, it may be preferable to wait until after a non-farm payroll report, the outcome of a Federal Reserve meeting, or an election, rather than unnecessarily exposing the client to a significant event with an unpredictable outcome akin to a coin toss.

Use of "Smart" Leverage

When an investor uses options to leverage their position, they amplify the potential returns on their investment. However, leverage is a double-edged sword. While it can magnify gains, it can magnify losses, using put spreads allows for the "dialing-in" of risk to the exact levels suitable for the investor. Smart Leverage in options is using option spreads to exactly define maximum loss and NEVER exceeding those levels.

Let's walk through an example of using leverage with defined risk: (see chart 3)

The advisor has determined suitability and decided to implement a put-spread strategy to potentially increase risk-adjusted returns. The investor has a $10 million portfolio, with $6 million allocated to equities and $4 million to bonds. The advisor aims to generate approximately $200,000 in annual income (risk premia), which is equivalent to 5% of the $4 million. Therefore, she allocates a notional value of $4 million to the 30-day put spread strategy and opts to cap the maximum loss of the put-spread strategy at 6% of the total portfolio value; 6% of $10 million equals $600,000. Consequently, the maximum loss on the spread amounts to 15% of the $4 million, which will occur only if the S&P 500 falls by 15% or more. The investor uses the bonds in the portfolio as "collateral" for the $600,000.

At present, XSP (1/10 of SPX) is trading at 504. The advisor determines that selling the 488 strike in 30 days (premiums omitted for simplicity) will satisfy the 5% income target she has set. She divides $4 million (notional value to layer on the portfolio) by $48,800 (488 x 100) to arrive at 82 contracts. To cap the downside at 15%, she selects 415 as the other "leg" of her trade (415 is 15% below 488). The spread, selling 82 XSP Put 488 and buying 82 XSP Put 415, is sold for a "credit" with the options expiring in 30 days. XSP options are European style, meaning they can only be exercised at expiration (although they can be sold in the secondary market at any time). If the XSP is trading above the sold strike of 488, the proceeds from the spread will be booked as profit (income). If XSP trades below 488 at expiration, resulting in a loss, the investor can choose to:

• Use margin to cover loss with hopes to pay off margin with future gains

• Sell the collateral

• Use funds from another source

Chart 3

Tax Advantages

The benefits of 1256 contracts are not well-known in the retail advisory space by either advisors or clients. Our recommendation is for advisors to educate themselves on both options, 1256 contracts, and the potential tax advantages afforded to their clients. Index options that qualify as Section 1256 contracts benefit from the 60/40 rule. * According to IRS Publication 550 "Under the marked-to -market system 60% of your capital gain or loss will be treated as a long-term capital gain or loss and 40% will be treated as a short-term capital gain or loss. This is true regardless of how long you actually held the property."

As previously mentioned, there is one potential tax benefit of 1256 contracts that is rarely discussed. *The loss carryback election afforded to 1256 contracts is, in my opinion, a game-changer. From IRS Publication 550: "An individual having a net section 1256 contracts loss can generally elect to carry this loss back three years instead of over to the next year the laws carried back to any year under this election cannot be more than the net section 1256 contracts gained in that year."

In our experience, advisors with knowledge of this domain tend to experience enhanced client retention and benefit from increased referral rates from CPAs. These referrals are based on merit rather than the anticipation of reciprocal actions, indicating that CPAs recognize and trust the advisor's expertise to provide superior counsel to their clients.

Cboe Global Markets offers an impressive array of resources that can significantly enhance your ability to serve your clients effectively. By leveraging these tools, you may even enhance client outcomes. I firmly believe that the most effective advisors are those who consistently push beyond their comfort zones, committing to continuous learning for the ultimate benefit of their clients.

*Please consult a tax attorney or CPA, as I am not a tax expert or CPA

About the Author

Rob Emrich has over 20 years of investment experience. Rob began his financial services career in 2000 as a financial advisor with Morgan Stanley. He has since worked in the fields of consulting services and money management, including his work as Vice President with Alliance Bernstein and Director with Janus Capital, where he raised over $1 billion for these investment managers.

In 2010, he developed an algorithmic commodity trading system and ran a portfolio for four years, trading over $4 billion in notional value of oil and gas, interest rate and foreign currency futures. Rob is currently involved in developing and managing investment strategies, including the use of index options for hedging market risk and volatility. Rob has been quoted extensively on his market insight by Forbes, CNN Business, Business Insider, Wharton Business Radio and Yahoo Finance.

This article is part of Cboe's Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email [email protected] or contact your Cboe representative to learn more.

Disclaimer: There are important risks associated with transacting in any of the Cboe Company products or any digital assets discussed here. Before engaging in any transactions in those products or digital assets, it is important for market participants to carefully review the disclosures and disclaimers contained at: . These products and digital assets are complex and are suitable only for sophisticated market participants. These products involve the risk of loss, which can be substantial and, depending on the type of product, can exceed the amount of money deposited in establishing the position. Market participants should put at risk only funds that they can afford to lose without affecting their lifestyle. The views of any third-party speakers or third-party materials are their own and do not necessarily represent the views of any Cboe Company. That content should not be construed as an endorsement or an indication by Cboe of the value of any non-Cboe financial product or service described.