Index Option Writing
Why an Underutilized Investment Strategy is Gaining Favor
Pressured by historically low interest rates, many institutional investors have spent the past
few years edging into higher-risk assets in search of yield. Now, with short-term rates moving
up, equity valuations high and the global political climate marked by uncertainty, a time-
tested investment and risk-management tool—index option writing—is looking increasingly
attractive. Chief Investment Officer spoke recently with Derek Devens, Managing Director at
investment management firm Neuberger Berman Investment Advisers LLC, about how asset
owners are using option strategies not just to manage risk but also as a pure source of return.
CIO: Asset owners are always looking for new investment
ideas and new ways to be more risk efficient, but options
aren’t new. Why are people turning to them now?
DEREK DEVENS: Like any industry, investment management
has an innovation curve, and in some cases it can take a long
time to move from specialized implementations of an idea to
broader application. Sophisticated investors have long utilized
the optionality that’s embedded in many types of securities:
convertible bonds, asset-backed securities, stock warrants, and,
of course, swaps. Given the lower return, risk-aware environment
we’ve witnessed over the past several years, more conservative
option-writing strategies—put-writing, buy-writing and overwriting—are finally moving along that innovation curve.
CIO: How exactly does this work? What strategies are you
DEVENS: One of the most common strategies we use is
collateralized put-writing, where, on our client’s behalf, we sell
put options on an equity index and invest their collateral in
short-duration U.S. Treasury bonds. This allows our client to
collect two different return sources—the premium they collect
for selling the options, and the bond income. If the index stays
above the option’s strike price, the client earns the full amount of
those two sources of return. If the index falls to the strike price or
below it, the client loses money because they have to pay the put
holder the difference between strike price and the index price.
So you do have the full downside exposure of the index, but the
downside risk is mitigated by the premiums they received for
selling the put, plus any interest earned on their collateral. It’s
important to note that the premiums can increase significantly
during periods of market uncertainty.
Our second strategy builds on the first. It’s an index strangle
where, in addition to implementing the collateralized put-writing,
we sell, or write, call options on the same index. This strategy
is much less dependent on the direction of the market than
collateralized put-writing and at times may even be negatively
correlated with the market. Finally, we can implement either
of these two strategies as an overlay to increase the capital
efficiency of an existing portfolio allocation.
CIO: Passive investing is more popular than ever. Options
are a type of derivative, and investing in options probably
seems to a lot of people like the antithesis of passive investing.
How do you square the appetite for these two seemingly
contradictory approaches to investing?
DEVENS: Actually, we suspect they may have something of a
symbiotic relationship. As index-based investing has grown, so
has the focus on risk control. If no one is actively manning the
stock portfolio, then if someone wants to manage the risk of that
portfolio further up the chain, at the asset-allocation level, then
options can facilitate that.
CIO: But to be clear, you’re running actively managed
DEVENS: That’s correct. Options are always expiring, so even
with a passive strategy the portfolio would be turning over with
regular frequency; you’d be rolling your options as they expired
or approached expiration. We run a systematic, rules-based
strategy. It’s not a tactical or an opportunistic approach, but
neither is it a passive strategy where we’re just naïvely rolling
options. At a practical level, we can’t advocate a traditional
passive approach to options. Exchange traded option markets
are transparent. If everybody knew what options we would be