Figure 13 shows the hypothetical profit and loss of a levered stock replacement trade on SPY compared alongside an investment in SPY. The stock replacement trade is long three at-the-money call options. By levering the notional, the more SPY continues to rally, the greater the stock replacement trade outperforms (thus allowing investors to catch up in a rally). On the downside, the loss is limited to the amount of upfront premium paid. As a reminder, these stock replacement positions required much less upfront capital than an outright purchase of SPY, and also provide downside protection in the case of large declines in SPY.
Overwriting And Alpha Generation
Because options performance is primarily dependent on the performance of the underlying asset, fundamental investors with a directional view have a potential edge. Strategies that sell options also have an advantage, as options generally trade rich to fair value. Option strategies such as overwriting and iron condors can help investors efficiently monetize their directional view and are risk-controlled ways to harvest the excess premium priced into options.
Overwriting as well as iron condor strategies have been well documented, analyzed and implemented within the equity asset class on single-stock and broad-market index options. Now, however, ETF options allow investors access to sectors and across asset classes when applying these strategies.
Example 5: Overwriting Specific Sectors In A Diversified Equity Portfolio
Take, for example, an investor who owns a diversified portfolio of large-cap stocks and is moderately bullish-to-neutral on specific sectors within the portfolio. To enhance yield, the investor decides to sell call options on names in the lower-conviction sector. With ETF options on equity sectors, instead of selling call options on each of the individual stocks, the investor can instead sell a call option on the specific sector ETF.