When Diversifying Has Too Many Downsides

Sheaff Brock, ducks with heads underwater signifying downside risks,

When Diversifying Has Too Many Downsides

Strategies for Concentrated Equity Positions
Part One: Covered Calls

Whether through love or happenstance, like many investors, you may have ended up with a very large investment position in one company or in several companies within the same industry. Perhaps you received stock from an employer as part of your retirement package. You might have inherited shares from a beloved family member. You might have intentionally built a big position in the shares of a company you admire. Whatever the reason for the concentrated equity buildup in one stock or industry, you now feel it would be a good idea to diversify that risk. Additionally, you’d welcome a more consistent income flow. It’s no mystery what’s been keeping you non-diversified (while possibly keeping you up at night)—the potential tax consequences of a sale.

Sheaff Brock derivatives portfolio manager James “Louie” Humphries, J.D., explains that there are a number of strategies that can help with both the need for income and with tax efficiency, using equity options alongside equity positions. Each strategy comes with unique benefits and risks. This article, explaining covered calls, represents the first in a series on the different ways in which equity options can be used as an investment strategy for concentrated equity positions.

Covered Calls

A covered call an options trading strategy in which the trader sells a call option while owning an equivalent amount of the underlying security. It is generally “written” (sold) at a strike price above the current price of the underlying equity (a portion of the concentrated equity position). See a visual representation below, in which point A is the strike price of the call option written, and in which the blue line represents the maximum potential gain or loss. The seller is obligated to sell the stock at the strike price.  (Source: optionsplaybook.com)

Sheaff Brock, covered calls strike price and profit-loss chart, diversifying downsides

Possible outcomes of a covered call transaction:

  • Selling a covered call on a concentrated equity position can produce income in the form of premium that is collected when the option is sold—and all with a goal of the option expiring worthless. (You want the price of the underlying equity to be at or below the strike price at expiration. If it is above the strike price at expiration, the option will be assigned and the stock “called away,” creating a tax liability.
  • Maximum profit is limited to the premium collected when the call option is sold. Potential loss is mostly embedded in the underlying stock, in that this option provides no protection to a downward move in the stock price. Opportunity cost may also be a concern. The stock price could appreciate quickly to the upside and those gains missed if the option is assigned.

Best practices to consider:

  • Not setting the strike price too low because, while that increases the premium collected, it also increases the likelihood that the stock will be called away through assignment. Instead, sell the call with a strike price you would be happy to receive if you were to sell the stock.
  • Using only a portion of your underlying position, which limits the likelihood of the position being called away or of missing a large upside.
  • Laddering the calls to allow writing over a series of strike prices and/or expiration dates.
  • Not “chasing” call options, but being willing to let the stock be called through assignment.

Option overlay strategy for concentrated equity positions

There’s nothing new about option overlays. In fact, the majority of U.S. pension plans have adopted overlay techniques as part of their investment tactics—using derivative investments with an underlying securities portfolio serving as collateral. At Sheaff Brock, we are in our third decade of helping investors with concentrated equity positions use protective portfolio tactics such as covered call overlays.

Perhaps, with professional help, diversifying your portfolio holdings can have an upside after all.

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