Improving portfolio diversification with option-based strategies

Until recently, finding an effective source of diversification for equity risk was low on the list of concerns for many asset allocators. Fixed income’s role in a classic 60/40 portfolio (60% equities, 40% bonds) was well established: providing a negatively correlated counterbalance to equities that also delivered low volatility and positive yield. The overall combination of return and risk served investors well for decades.

Stock market sell-offs tended to arise primarily from growth shocks, and sharp equity declines were offset by falling interest rates and rising bond prices. But today’s higher inflation environment has introduced greater uncertainty into this critical stock-bond relationship (Exhibit 1). Given the possibility that inflation—and interest rates—will remain elevated for some time, investors may want to consider alternative methods for managing equity risk.

Here, we propose a fundamentally different solution: Introducing new methods of diversification in the form of option-based strategies. These strategies specifically use options to trade some equity portfolio volatility and upside for steady, volatility-reducing income, but—unlike a traditional 60/40 portfolio model—they are not dependent on negative stock-bond correlation to mitigate risk effectively.

The benefits of different approaches to volatility reduction

In a classic 60/40 portfolio, negative stock-bond correlation is important, but not an absolute requirement for risk reduction—simply maintaining a 40% weight to lower volatility fixed income will reduce portfolio volatility. Exhibit 2 below clearly shows the lower volatility of stocks vs. bonds across time. Even in those relatively rare moments when positive correlations emerge and stock and bonds both lose value simultaneously, the magnitude of bonds’ downside risk remains well below that of equities. However, the lack of volatility is not ideal; a more effective hedge would result in an increased payoff in a down market.

The most important lesson may be that, because equities’ risk magnitude is far greater than that of bonds, relying on bonds’ negative correlation to manage equity risk is only partially effective. Strategies designed to respond positively to equities’ volatility may prove to be equally—or possibly more—powerful than using a 60/40 stock-bond allocation model.

Building a direct hedge via option-based strategies

Using option-based strategies takes some of the guesswork out of risk mitigation. Much like a traditional 60/40 portfolio, these strategies exchange some of the equity portfolio’s intrinsic volatility and potential upside for a regular stream of volatility-reducing income. This income is created by selling call options on the underlying equity portfolio, a process known as call writing. Investors then have a choice: They can either retain this income as a low-risk form of return or use the option premium to purchase explicit downside protection via equity put options (known as “collars”).

In practice, delivering an outcome similar to a 60/40 portfolio requires a systematic approach. Incorporating options into a broader equity strategy needs to be done in a disciplined way across time and through various market environments. There are numerous possible implementation approaches, including active strategies, which we explore later in this paper.

In Exhibit 3, however, we identify three passive systematic strategies that illustrate the potential benefits of using options. The first two are call writing strategies that generate option premium income; the third is a collared equity strategy that uses the option premium to purchase explicit downside protection via equity put options.

1. At the money (ATM) call writing: This strategy periodically sells ATM options (calls whose strike price is at or near the underlying security’s current market price) against the underlying equity portfolio—here, the S&P 500. This approach, represented by the CBOE S&P 500 BuyWrite Index (BXM), effectively removes the potential upside from the equity portfolio in return for maximizing the option premium. Downside risk remains unhedged, but the premium income offsets negative stock returns over time.
2. Partial call writing: This strategy also sells ATM options, but only at half the notional size of the underlying equity portfolio. This approach, represented by CBOE S&P 500 Half BuyWrite Index (BXMH), retains a portion of the equity upside while generating a more limited income stream. Functionally, this approach is similar to selling a larger notional option out of the money. Again, downside risk from equities is unhedged.
3. Collared equity: This variation deploys a collared equity strategy to purchase some downside protection in the form of put spread (going long a put and short a farther out of the money put) while simultaneously selling a call option of equivalent value to make the overall transaction effectively costless. This strategy, represented by the CBOE S&P 500 Zero-Cost Put Spread Collar Index (CLLZ), retains some upside and downside risk from the equity portfolio, but less than 100%.

Historical evidence suggests that these approaches may have merit as 60/40 portfolio substitutes. Exhibit 4 shows the cumulative performance of an investment in stocks, bonds, a traditionally diversified 60/40 strategy and the three representative examples of systematic option strategies. Stocks and bonds occupy both the high and low ends of the historical performance range, and the 60/40 portfolio falls roughly midway between those extremes—as do the options strategies.

By taking a closer look at the relative performance of these strategies, we can gain some useful insight:

• The call writing strategy (BXM), which maximizes income at the expense of equity upside, delivers returns closest to those of traditional fixed income. It lags fixed income during equity downturns, but more than compensates for that difference by delivering higher income over longer time horizons.
• The collared equity strategy (CLLZ) offers modestly improved performance relative to the call writing strategy, but that trajectory remains well below that of the 60/40 portfolio. This may be due to the persistent richness of equity put options across time and the asymmetric payoffs needed to cover the cost of relatively expensive equity puts with the sale of cheaper call options.
• The partial call writing strategy (BXMH) delivers performance that is nearly identical to that of the 60/40 portfolio throughout the period shown. This is an intuitive result, as the strategy’s blend of income and equity beta are broadly similar to the 60/40 portfolio’s exposures.

Introducing active management to an option strategy

We chose to use these strategies for illustration purposes because they have long track records, not because they represent optimal option structures. As passive systematic strategies, they all adhere to specific formulas that remain consistent over time and do not change with market conditions. More flexible structures might provide better performance, but will require some use of active decision making at various stages in the investment process.

Within the equity portfolio itself, well-established active management styles can limit exposure to downside risk and ideally improve the downside-upside capture ratio. These approaches work well with call writing strategies where the downside risk remains unhedged and there is potential to benefit from equity upside.

When using equity index options, active managers should consider the degree of basis risk between the equity portfolio and the options’ underlying equity benchmark. The index option market offers exceptional depth and liquidity, but this primarily applies to broad public benchmarks like the S&P 500. Buying and selling options on custom portfolios is less efficient, potentially to a degree that would reduce or eliminate the benefits of the strategy.

Not all basis risk is bad, however. If the call options being sold reference a public benchmark that exhibits greater volatility than the underlying portfolio, investors may come out ahead by generating greater option premium income.

Further, active managers can execute their option sales and purchases to avoid periods of time when crowded markets may push prices away from fair value. By using some degree of discretion, active managers can also prevent other market participants from anticipating—and attempting to front-run—transactions. 

The positive impact of active management can be significant. Exhibit 5 shows the performance of sample call writing and collared equity strategies that employ many of these techniques. Although the time horizon is limited to reflect actual performance, there is a striking improvement compared to the passive strategies described earlier.

Recall that in the earlier example, the collared strategy underperformed the 60/40 portfolio while the call writing strategy’s performance was virtually identical. Here, all three strategies deliver similar performance. However, it is worth noting that the correlation between stocks and bonds turned positive in the middle of 2022—and remained broadly positive through 2023.

What happened in 2022 deserves closer scrutiny. That year, as this positive stock-bond correlation reached levels not seen since the 1990s, the 60/40 portfolio fell by 16%, but the collared and call writing strategies only declined by 8% and 4%, respectively. While this limited time horizon does not allow us to draw definitive conclusions, the improvement we observed in performance—along with the visibly smoother pathway these option strategies took relative to the 60/40 portfolio—appear compelling.

Conclusion: Incorporating option-based strategies into portfolio risk management

This analysis suggests that option-based strategies could effectively substitute for a traditional 60/40 portfolio, but with potentially higher returns and lower volatility. Should investors replace their bonds, however? We don’t think so. The bond market, which currently offers yields well above recent historical averages, provides current income—and the potential for falling rates to deliver diversifying returns in a down market.

Stock-bond correlations have proven to be unstable and may stay that way. If inflation uncertainty is high, correlations are likely to remain elevated. If inflation fades, then correlations may well return to negative territory. Regardless, relying exclusively on a negative stock-bond correlation for risk diversification, which once felt like a safe course of action, may now be inadvisable.

A call writing strategy may be preferable during periods of low interest rates when the income from bonds is modest and fixed income’s diversifying power may be constrained. A collared equity strategy may be preferable during periods when equity valuations are extreme—and the risk of a move to the downside appears elevated. In practice, investors may need to tailor their approach with a mix of strategies that broaden their sources of portfolio diversification.

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