In the dictionary, an overlay is defined as something laid as a covering over something else.
In the construction field, for example, graphic overlays tell equipment users what buttons on a piece of machinery or on a vehicle need to be pushed. Overlays can make industrial equipment scratch-resistant, flame-retardant, or anti-glare, and can help products last longer. In the medical field, antimicrobial materials can overlay switches and membranes for protection and safety instructions. In computer technology, overlaying is a programming method that allows programs to be larger than the computer’s main memory, while overlay networks improve routing of information over the Internet. In photography, overlays are images or textures that are added as additional layers to a photograph.
In the world of investments, overlaying a basic portfolio with options may help enhance overall distributions to shareholders.
How does the strategy work? A fundamental portfolio of stocks and/or bonds first must be constructed, perhaps with a dual goal—growth through potential capital appreciation of the shares themselves as well as from dividend and interest income. Then, “on top of” that basic portfolio, an option overlay is constructed with the goal of providing additional income derived from option premiums.
“Looking into” option overlays:
The underlying principle behind option strategies is to take advantage of the difference between implied volatility and actual volatility in the marketplace. For example, the VIX® Volatility Index is constructed using Standard & Poor’s 500 Index options, measuring the ratio of the number of put options as compared to the number of call options being bought. In overlays, the idea is measuring the degree of movement rather than the direction of the movement (up or down). The overlay has the potential to enhance overall portfolio results by generating premium income (expiration of the spreads between short and long put options generates profit).
But aren’t all options, by definition, high risk?
Through the use of options and futures, the Chicago Board of Trade explains, volatility can actually be used to reduce risk in three ways:
- diversifying into assets with negative correlation to the broad market
- hedging a stock or fund portfolio
- generating income
Option overlays can step into the post-business liquidation breach.
Following the sale of a family-owned business, one problem the seller often experiences is severely reduced income flow. Premium income from options may be one way to fill in the gap. Option overlays allow the owner to deploy the proceeds of his or her business liquidation in stages, “backing into” new investment positions rather than taking an all-at-once approach.
Meanwhile, investors looking ahead a decade or two towards retirement will find that small and regular incremental returns during the asset accumulation phase can make a very meaningful difference in income levels post-retirement. One study, based on hypothetical investments in the Morningstar Moderate Target Risk Index from 1994 through 2018, showed that boosting the annual average return by only 250 basis points would have resulted in a doubling of the portfolio’s ending value! Visit the Sheaff Brock YouTube channel for timely investment insights.
Option overlays, laid as a “cover” over a basic portfolio, can help increase portfolio diversification, safety, and reach.