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Common Misconceptions About Option Strategies: What Advisors Need to Know

Options can be a powerful tool for financial advisors looking to enhance client returns, manage risk, and potentially exit a concentrated position in a tax-efficient manner. However, many advisors hesitate to incorporate options due to widespread misconceptions. In this article, we’ll debunk some of the most common myths about option strategies and provide insights into how advisors can effectively leverage them for their clients.

 

Misconception #1: Selling Options is Too Risky

One of the most persistent myths is that selling options is inherently dangerous. While certain strategies—such as selling naked calls—carry significant risk, selling options strategically against equity holdings can enhance portfolio returns while maintaining controlled risk exposure. Strategies such as covered calls and cash-secured puts allow advisors to generate consistent income while maintaining defined risk limits. The key is understanding the risks and structuring trades appropriately to align with investment objectives.

 

Misconception #2: Options Are Only for Speculators

Many advisors assume that options are tools meant only for aggressive traders looking to make quick profits. While this may be true with regard to speculatively buying options, option-selling programs can play a crucial role in conservative portfolio management. Advisors can use option overlays to generate additional income through covered call strategies or sell puts to enter stock positions at more favorable prices. When used correctly, selling options can provide an additional layer of risk management rather than being purely speculative.

 

Misconception #3: Options Are Too Complex for Clients to Understand

It’s true that options involve additional layers of complexity compared to traditional stock investing. However, that doesn’t mean they are incomprehensible or unusable. Many advisors successfully incorporate option-selling strategies by educating clients on their benefits and risks in a straightforward manner. Explaining how a covered call generates additional income makes these concepts more digestible for clients. Clear communication and proper risk management help bridge the knowledge gap and make more options accessible. Advisors who don’t have the requisite knowledge or time required to implement these strategies can hire an outside expert like Exceed.

 

Misconception #4: Selling Options is a High-Volatility Strategy

While strategies such as covered calls or collars can be very beneficial in volatile markets, selling options is not solely a high-risk, high-volatility play. Even in low-volatility environments, selling options can provide ongoing income and improve portfolio efficiency. Covered call strategies work best when markets are flat or slowly rising, but they can also be profitable in strong bull markets. By structuring trades correctly, advisors can benefit from different market conditions, not just volatile ones.

 

Misconception #5: Options Are Too Expensive to Implement

Some advisors believe that options are costly due to margin requirements or potential losses. However, many option-selling strategies involve well-defined risks that can be managed with proper portfolio allocation. Covered calls, for example, do not require additional capital beyond owning the underlying stock, and cash-secured puts ensure that sufficient cash is available to buy the underlying stock if assigned. With low-cost option trading now widely available, cost barriers are lower than ever.

 

Final Thoughts

Misconceptions about options have led many financial advisors to overlook their potential benefits. However, when used strategically, selling options can be a valuable tool for generating income, managing risk, and enhancing tax efficiency. By debunking these common myths and educating both themselves and their clients, advisors can take full advantage of what option-selling strategies have to offer. Instead of viewing options as overly risky or complex, advisors should see them as a flexible instrument that, when properly implemented, can improve client outcomes and portfolio resilience.

 

 

 

 

 

 

IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. No strategy can prevent all losses or guarantee positive returns. Options trading involves risk and does not guarantee any specific return or provide a guarantee against all loss. Clients must be approved for options trading at the custodian holding their assets, and not all retirement accounts are permitted to trade options. Transaction costs and advisory fees apply to all solutions implemented through Exceed and will reduce returns.

The Power of Using Options in Retirement Accounts

At first glance, you might be thinking I’m insane to even be mentioning options and retirement accounts in the same breath. After all, options are meant for rampant speculation and are super risky, right? While they can be used for “gambling” purposes if so desired, options are flexible instruments that have a wide variety of uses and benefits, even in qualified retirement accounts such as an IRA.

The main benefit of investing in an IRA is that taxes are either deferred until the money is withdrawn (traditional IRA), or the account can be funded with after-tax dollars and grow over time without accruing any tax liability (Roth IRA). I won’t get into the details too much here, but Roth IRAs generally aren’t available to high-income households, though there are some workarounds. What’s important to note is the potential power of tax deferral and the effect that it can have on a retirement portfolio. This benefit is amplified when using an income-generating strategy such as writing covered calls against existing stock holdings.

Consider a hypothetical portfolio of $100,000 that’s fully invested in equities. Let’s assume, to illustrate the math, that this portfolio returns 8% every year for 30 years, there are no annual contributions, and the investor implements a covered-call overlay strategy that generates an additional 3% annually in yield. The yield-generating potential of each portfolio depends on the volatility of its holdings, but we think 3% annual yield via covered calls is a conservative assumption. We’ll also assume that this investor is married and sits in the 22% tax bracket, which indicates a total household income range of $89,450 to $190,750 for 2023. For simplicity’s sake, we’ll also assume that no stock holdings are sold at any point until the end of this 30-year period. Lots of unrealistic assumptions here-especially the lack of volatility, which is obviously significant in the real world-but the simplicity helps make the point about the effect of taxes, since that’s the only factor that differs in the three scenarios shown.  Here’s what the growth of this hypothetical portfolio would look like over time. The “Portfolio value” column is a beginning of year number.

Profits from covered calls are taxed as capital gains, and in this example the tax rate is 22%. This tax liability is subtracted from the portfolio value every year and is a drag on the effects of compounding. The stock gain at the end of this 30-year period is taxed at 15%, the long-term capital gains rate for married couples earning $89,251-$553,850 annually. While this hypothetical investor accumulated significant wealth over this period, the taxes due each year from the covered-call returns were a drag on total returns.

Now let’s look at the numbers had this $100,000 originally been held in a traditional IRA. The assumptions remain the same as the example above in the taxable account, but the tax treatment is different. In a traditional IRA, all taxes owed are deferred until retirement, which we’re assuming is in 30 years. The tax rate on all gains in a traditional IRA is the income tax bracket that the investor resides in, which in this case is 22%. Both the stock and dividend profits will be taxed at 22%, but not until the end of this thirty-year period.

The deferred tax treatment in this case led to an additional net return of 0.22% annually. While this doesn’t seem like much on the surface, this can be significant over 30 years. In this example, that equated to an additional $103,936 in portfolio value! This amount would be even greater over a longer time horizon, or if the assumed returns were higher.

Lastly, let’s look at the numbers if this hypothetical portfolio was in a Roth IRA. Roth IRAs allow for all gains to grow tax free. The drawback to Roths is that there are annual contribution limits, income requirements, and if you roll an existing retirement account into a Roth IRA, you’ll likely owe income taxes on that money at inception. Most retirement accounts are funded with pretax dollars whereas a Roth IRA is funded with post-tax dollars. However, once this one-time tax is paid, you’ll never have to pay another penny in taxes on that account, assuming the appropriate rules are followed.

As you can see, the effect of not having to pay annual or terminal taxes on this account is substantial. An additional 0.87% net return annually (via tax savings) from a Roth IRA versus a traditional IRA equated to $481,631 more in portfolio value at the end of this period. This is a great example of how being tax savvy at the margin can have a dramatic effect on wealth as time goes on.

Retirement accounts aren’t generally where you see option activity, but small return enhancements over time can really add up. Using a covered-call overlay strategy inside of a tax-advantaged account can reduce volatility, potentially increase returns on both an absolute and risk-adjusted basis, and have a significant effect on retirement wealth.

 

 

IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. No strategy can prevent all losses or guarantee positive returns. Options trading involves risk and does not guarantee any specific return or provide a guarantee against loss. Clients must be approved for options trading at the custodian holding their assets, and not all retirement accounts are permitted to trade options. Transaction costs and advisory fees apply to all solutions implemented through Exceed and will reduce returns.

How to Use Options to Invest Like Warren Buffett

Warren Buffett is undoubtedly one the most famous and successful investors of all time, yet his strategy is very simple and straightforward – invest in companies that have solid fundamentals, a stable and growing business, and pay dividends. A dividend is simply a portion of the company’s earnings (or in some cases, reserves) that they choose to pay to investors instead of reinvesting in the company. While it’s not guaranteed to always be a set amount or paid in perpetuity, a dividend generates returns for investors even when the price of the company’s stock fails to appreciate. This creates a built-in buffer against volatility and allows the investor to either purchase more shares of the company with this recurring income or simply pocket the payments for use elsewhere. The amount of cash generated via dividends by Buffett’s Berkshire Hathaway is staggering and continues to increase. In 2022 alone, the company received over $6B in dividend payments from its equity holdings.

Recent market trends have many investors reaching for yield, and allocations to dividend-generating investments have exploded in the past year. Two of the more popular vehicles for income-based ETF investing are the JPMorgan Equity Premium Income ETF (JEPI) and The Amplify CWP Enhanced Dividend Income ETF (DIVO) by Capital Wealth. Both instruments employ an active management strategy where the fund holds a portfolio of mature dividend-paying companies and then overlays a covered call strategy against the stock positions. The use of covered calls limits upside for each equity holding over a specified timeframe, but in return the fund receives a steady stream of payments via option premium. This income stream decreases volatility and potentially enhances returns on both an absolute and risk-adjusted basis.  These strategies may work well if you are comfortable with the respective ETF managers selecting the underlying securities – if you prefer to select your own exposure and have a specialty manager assist in a covered call overlay, a firm like Exceed can help in the portfolio construction and management via an SMA.

 

Increase in Assets Under Management Over the Last Year

 

                                        courtesy of YCharts

 

The top stock holdings in income-based ETFs generally include companies like VZ, PG, UNH, HSY, PEP, and V. These are considered value investments with businesses that are mature, have stocks that trade at or below average market volatility, and for the most part are growing revenue at modest rates.  As a result of these companies’ strong position in the market, management has chosen to return a portion of its profits to investors instead of reinvesting in company-specific ventures. Investing in a diversified portfolio of these types of companies is typically relatively safe and suitable for those with a lower risk tolerance, but potential future upside is expected to be limited when compared to smaller growth or technology companies. Income-based ETFs are often good choices for those close to retirement age, but they’re not for everyone.

Many active investors have an affinity for companies with big growth potential and stocks that trade above average market volatility levels.  The tradeoff to investing in growth stocks like TSLA, NVDA, and PLTR is that very few of them pay a dividend – a holder of one of these companies is forfeiting a stream of regular dividend payments for the prospect of excess future returns. While “value” stocks tend to have lower volatility and higher dividends, growth stocks have the opposite – low dividends and higher volatility. Option prices are a function of volatility, with higher volatility driving higher option prices and premiums. As a result, you can generate higher yield writing covered calls on growth names versus value investments. While a practitioner of this strategy may be giving up some upside at times, at other times they will be rewarded handsomely for doing so. Everything else being equal, holding a stock with above average volatility and tactically writing covered calls against it creates the potential for both significant price appreciation and yield generation.

Options offer strategic advantages in different market environments, and many professional investors use them to their advantage on a regular basis – even Warren Buffett, king of buy-and-hold value investing, uses them as part of his strategy.  Selling covered calls can significantly enhance total portfolio returns, but structuring and managing these strategies can be tedious and complex. The team at Exceed Advisory has over 40 years of collective professional options experience and can simplify the process for you and your clients. Contact us for a consultation as to how you can use options as an overlay to an existing model portfolio to create your own dividend stream.

 

IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. Hedging does not prevent all losses or guarantee positive returns. Options trading involves risk and does not guarantee any specific return or provide a guarantee against loss. Clients must be approved for options trading at the custodian holding their assets. Transaction costs and advisory fees apply to all solutions implemented through Exceed and will reduce returns.

 

* JEPI and DIVO are not affiliated with or recommended by Exceed Advisory. We are using these two popular ETFs solely to illustrate how a general market strategy that may effectively serve retail investors at relatively low cost differs from Exceed’s approach. Exceed’s options overlay advice is tailored to the specific holdings of the client and will generally result in higher investment costs than a pooled mass-market solution, such as an ETF.