NASDAQ-100 Index Call Writing Overlays

By: Derek Devens, CFA, Senior Portfolio Manager, Option Group
Beryl Lou, Research Analyst, Option Group
Rory Ewing, Portfolio Manager, Option Group
Rachel White, CFA, Portfolio Specialist, Option Group
Eric Zhou, Portfolio Manager, Option Group

Monetizing Low-Cost Basis Stock Positions while Preserving Long-Term Stock Alpha

Generational wealth creation in global equity markets has created unique challenges for investor portfolios. Specifically, large single-stock positions become low-cost basis assets—essentially ‘dormant assets’—with limited but productive attributes, including long-term capital appreciation, dividend potential and/or sources for long-term charitable giving.

Hence, to date, some investors have pursued single-stock covered call (buywrite) strategies to generate additional portfolio cash flows. We believe this narrow strategy focus has been driven by a combination of its simplicity, investment platform limitations, and a lack of client awareness. We believe the growing needs and sophistication of taxable investors is paving the way for the introduction of efficient index-based solutions. Below we outline some of the potential merits of implementing NASDAQ-100 Index option call writing overlays versus the more traditional single- stock option covered call writing approach.

Executive Summary

Large single-stock positions with limited upside present a unique challenge for taxable investors. To generate extra returns, investors may employ “covered-call” (or “buywrite”) strategies, whereby they collect premiums for selling call options on their shares. If the stock price stays flat or falls, the investor keeps both the shares and the option premiums, thus enhancing returns; if the stock appreciates, the investor may have to sell the shares at the option strike price, forgo the additional upside and take a significant tax hit. In this short piece, we’ll show you how selling NASDAQ-100 Index call options may offer a potentially superior, more tax-efficient way to generate additional cash flows from large single-stock positions.

NASDAQ-100 Index Options

The NASDAQ-100 is a bellwether U.S. stock index focused on innovative companies that have generated unparalleled levels of investor wealth. With its success has come an institutional index option market offering deep liquidity and cost-efficient contract sizes. Below are estimates of the growth of NASDAQ-100 (NDX) Index option open interest and average monthly notional volume in U.S. dollars. We believe the size and scope of the NASDAQ-100 Index option market can support large scale, systematic investor solutions without suffering insufficient liquidity or abnormal transaction costs.

Preserving Single-Stock Alpha

Investors with a significant portion of wealth in a company’s stock generally wish to participate in some portion of the enterprise’s future long-term upside potential. Yet systematically ‘selling away’ the upside of a concentrated low-cost basis stock position, i.e. writing a covered call option, seems to run contrary to this long-term investment goal and, in our opinion, may be a suboptimal investment strategy from alpha, capital, and tax perspectives.

The chart below illustrates the 5-year beta and correlation of the Top 20 constituents of the NASDAQ-100 by market capitalization (approximately $15T in market capitalization) versus the NASDAQ-100 Index. From this chart we can see that the beta and correlation of the Top 20 to the NASDAQ-100 Index are sufficiently high for index call writing on low-cost basis stock positions to provide an attractive alternative to single-stock covered call writing.

A NASDAQ-100 Index call writing overlay can be tailored appropriately to limit index basis risk and preserve participation in the long- term capital appreciation of the underlying single-stock positions. Such a strategy can improve the utilization of ‘dormant’ portfolio positions, avoid ‘assignment risk’ of low-cost basis positions and improve the overall risk efficiency and tax treatment of investor portfolios. The figures below compare various hypothetical models of single-stock 30-delta covered call strategies (“Covered Call Strategy Model”) versus NASDAQ-100 Index 25-delta call overlays (“+ NDX Call Writing Overlay Model”) on the respective Top 5 NASDAQ-100 constituents: Apple, Microsoft, Amazon, Google and Nvidia. Note, we select a marginally lower delta strategy for the index call writing overlay (25-delta vs. 30-delta) to account for potential basis risk between the underlying single stock position and the index. In each of these examples, an index call writing overlay generally offers superior upside participation, meaning the index- based call strategy allows the underlying stock to appreciate. Whereas the comparable single-stock covered call strategies explicitly limit the return potential of the underlying stock. The net results are equal or improved risk efficiency versus the single-stock covered call strategy. Intuitively, NDX call writing benefits from similar short equity exposure (negative delta) but avoids some of the extreme ‘right-tail’ events that occur in single stocks which can increase the return of the combined portfolio (long stock + short NDX call) versus the single-stock covered call strategy.

Typical Portfolio Overlay Structure

In addition to maintaining upside participation and improving risk efficiency, a NDX call writing overlay strategy can also increase
the capital efficiency of investor portfolios. Rather than directly posting a single stock position as ‘collateral’, an index option overlay strategy is free to source margin release across an investor’s existing multi-asset portfolio. For example, a $10 million position in Stock A would generally allow for up to $5 million (50%) in margin release. For comparison, a traditional Stock A covered call strategy’s short call option position directly restricts an equivalent amount of stock shares (a source of assignment risk and/or taxable events), essentially locking up (consuming) the full margin ability of the Stock A positions. In contradistinction, $10 million notional (mandate size) of index call writing would require approximately $2 million (20% of notional) in margin requirement which is only 40% of Stock A position’s $5 million in margin release.

Our experience informs us that one of the primary hurdles for implementing an index call overlay versus the more traditional covered call strategies is a potential requirement to open a new multi-margin account to hold the index call options versus using a simpler brokerage account format the permits single-stock covered call writing. However, we believe this is a legacy issue due to a lack
of investor education and preference to avoid perceived complexity. The merits of the index overlay solution more than justify the incremental work involved in account setup.

Premium Tax Treatment & Flexible Gain/Loss Allocation

For tax purposes, single-stock covered calls are treated at 100% short-term capital gains while index option writing strategies can benefit from their unique treatment under U.S. Internal Revenue System (IRS) Section 1256, which categorizes gains and losses as 60% long-term / 40% short-term capital gains. Finally, 1256 allows gains/losses to be realized at year-end even from positions that are still open, guaranteeing an opportunity to utilize some realized taxes, while single-stock options only generated realized gains/losses from positions that have been closed prior to year-end.

Let’s walk through a few short hypothetical scenarios. Assume a $2 million NASDAQ-100 Index option call writing overlay using low- cost position Stock A as margin release generates $100,000 in net cash flow (5% gain) for the year. After tax gains can be used to: 1) simply reinvest elsewhere and further diversify an investor’s portfolio, or 2) pay capital gains generated from selling a portion of the position in Stock A that creates a tax bill equivalent to the gains. The second scenario essentially allows an investor to slowly reduce exposure to Stock A with reduced tax consequences and without affecting other portfolio assets.

On the other hand, if the index option call writing overlay realized a loss, then the loss can be used to offset gains, including long-term capital gains since the options receive 60% long-term capital gains treatment. In general, utilizing index options for overlay strategies can potentially afford taxable investors greater tax management flexibility than traditional single-stock covered call writing strategies.

Tactical Isn’t Practical

Systematically writing call options on single-stock positions through periods of price drawdowns can prove detrimental to recovering losses despite the higher option premiums that tend to coincide with the stock price decline. More specifically, selling call options on a single-stock position can explicitly cap the return potential of the stock if its price were to recover. Predictably, this challenge can lead some advisors to contemplate tactical approaches that, in our opinion, carry as much if not more reputational risk for advisors than investment reward.

Successful tactical decision-making around when to turn a single-stock call writing program on or off requires an investor to forecast the price direction of the single-stock and whether the single-stock volatility is attractively priced—two stock-picking tasks we believe are impossible to do consistently over longer time periods. Hence, in our experience, one of the advantages of index options is their diversified exposures and their efficiency at pricing equity market risk. In turn, we believe, systematic index call writing strategies tend to offer more robust and productive outcomes for advisors and their end investors. 

Final Thoughts

When faced with the current market dynamics of higher equity volatility and potentially stagnating equity markets, we find the ability to generate an incrementally diversifying, relatively tax efficient cash flow to be preferred by many investors over simply ‘selling away’ the upside in concentrated low-cost stock positions that, in part, helped generate a large portion of a client’s wealth. In some cases, investors’ emotional investments in the continued success of companies they helped build is enough to warrant an index option call writing overlay that can be systematically maintained without directly risking the stock position in lieu of a single-stock covered call strategy. At a minimum, taxable investors deserve to know there are other options than single-stock options.

1 Index options may be eligible for tax treatment as 1256 contracts at 60% long-term and 40% short-term. Overlay strategies involve the use of leverage. See leverage risk disclosures at the end of this material.

2 Source: Bloomberg LP.

3 Source: NASDAQ, Bloomberg LP. Alphabet (Google) is consolidated as one position for purposes of calculating the top 20 NASDAQ-100 Index constituents.

4 Source: Bloomberg LP, Neuberger Berman. The results of the model covered call strategies are hypothetical and for illustrative purposes only. They results do not represent the performance of any Neuberger Berman product or strategy and do not reflect the fees and expenses associated with managing a portfolio. See “Hypothetical Model Illustrations” and the end of the material for information on the hypotheticals results, including assumptions. The hypothetical growth illustration shown reflects the growth of a hypothetical investment in the model(s) and index(es) as of the date indicated and assumes reinvestment of any dividends and distributions. Results shown are hypothetical and do not represent the returns of any particular investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. See Additional Disclosures at the end of this material which are an important part of this presentation.

Hypothetical Model Illustrations

The hypothetical model results included in this material are of various hypothetical model strategies, including simulated backtested models, that are shown for illustrative purposes only. The results do not reflect actual performance results. The hypothetical results we calculated by running the hypothetical/model portfolios using the stated methodologies and assumptions. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the hypothetical results have been stated or fully considered. Changes in the model assumptions may have a material impact on the hypothetical returns presented. The results do not represent the performance of any Neuberger Berman product or strategy and do not reflect the fees and expenses associated with managing a portfolio strategy. There are frequently material differences between hypothetical performance results and actual results achieved by a portfolio. Unless otherwise indicated, results assume no withdrawals or additional contributions and reinvestment of any dividends and distributions.

Hypothetical performance has certain inherent limitations. Unlike actual investment performance, hypothetical results does not represent actual trading and accordingly the performance results may have under- or over-compensated for the impact, if any, that certain economic or other market factors, such as lack of liquidity or price fluctuations, might have had on the investment decision-making process or results if assets were actually being managed. Hypothetical performance may also not accurately reflect the impact, if any, of other material economic and market factors, or the impact of financial risk and the ability to withstand losses. Hypothetical performance results are also subject to the fact that they are generally designed with the benefit of hindsight and established at a point in time. As a result, the hypothetical assumptions, including any asset allocations, could theoretically be modified in order to produce more favorable simulated performance results. In addition, the results are based, in part, on hypothetical assumptions. Certain of the assumptions have been made for modeling or simulation purposes and may not have been realized in the actual management of accounts. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the hypothetical results have been stated or fully considered. Changes in the hypothetical assumptions may have a material impact on the hypothetical returns presented. To the extent a hypothetical portfolio or asset allocation includes asset class returns, such returns are for illustrative purposes only and not reflective of the returns of a specific strategy. There are frequently material differences between hypothetical performance results and actual results achieved by any investment portfolio or strategy. Unless otherwise indicated the target allocations are static with no rebalancing, contributions, withdrawals, redemptions or corporate actions and reinvestment of any dividends or distributions.

This following is a summary of simulated models show and the associated methodology and assumptions:

AAPL Covered Call Strategy Model, AAPL w/ NDX Call Writing Overlay Model, MSFT Covered Call Strategy Model, MSFT w/ NDX Call Writing Overlay Model, AMZN Covered Call Strategy Model, AMZN w/ NDX Call Writing Overlay Model, GOOGL Covered Call Strategy Model, GOOGL w/ NDX Call Writing Overlay Model, NVDA Covered Call Strategy Model and NVDA w/ NDX Call Writing Overlay Model

The option strategy back-testing platform is designed to estimate historical performance of portfolios that implement systematic option writing strategies. Models support a multitude of variables including option strategy, e.g., put writing or call writing, underlying exposure (index or stock), tenor, moneyness, risk management parameters and collateral investments. While models incorporate different parameter sets, they adhere to a consistent structure across all back-tested model scenarios and our model architecture is such that returns are estimated independent of account size.

All models rely on a Black-Scholes pricing to estimate option prices based on historical implied volatility surfaces. We compile daily implied volatility surfaces from exchange listed option price and/or option implied volatility data available from external data providers including the Chicago Board of Options Exchange (“CBOE”) and Bloomberg LP. Additional inputs for option pricing (dividends, risk-free rate, etc.) are sourced from Bloomberg LP.

Daily implied volatility surfaces allow models to price weekly expiration dates even though weekly option expirations may not have been actively traded on an exchange over the full history of a model back-test. Models methodically allocate options across weekly expirations to promote diversification across expiration dates and are assumed to settle on each Friday consistent with current option market practices.

Exposures are rebalanced on a daily basis at the close of each trading day. Daily model rebalancing adjusts portfolio exposures and rolls (covers and writes) option positions consistent with specified risk management targets. Options are rolled in a manner that seeks to preserve exposures across multiple expiration dates, and risk management targets, e.g., option delta and or moneyness, are set at the inception of a back-test and applied over its full history. All trading is assumed to be transacted at market closing prices derived from closing implied volatility levels and includes estimates for transaction costs. Option strike prices follow standard option market conventions unique to the underlying index/security. Models may round up, down or to the nearest strike price when selecting option to write.

Funded/collateralized models assume fully collateralized such that model portfolios are assumed to hold fixed income securities whose aggregate market values are greater than or equal to the aggregate notional exposure of the options. Collateral is assumed to be invested in a widely followed index(s) that approximates the performance of short-term U.S. Treasuries. Models may vary from actual strategy performance due to assignment risk for American style options, exchanged traded option contract availability, intra-day trading and differences in transaction costs (implicit and explicit).

Overlay overlay models assume sufficient collateral and no margin calls, but do not reflect investment of collateral or any appreciation or depreciation thereon. Models may vary from actual strategy performance due to assignment risk for American style options, exchanged traded option contract availability, intra-day trading and differences in transaction costs (implicit and explicit).

Additional Disclosures

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. The firm, its employees and advisory accounts may hold positions of any companies discussed. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. References to third-party sites are for informational purposes only and do not imply any endorsement, approval, investigation, verification or monitoring by Neuberger Berman of any content or information contained within or accessible from such sites. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

Discussions of any specific sectors and companies are for informational purposes only. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory accounts may hold positions of any companies discussed. Nothing herein constitutes a recommendation to buy, sell or hold a security. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable.

Options involve investment strategies and risks different from those associated with ordinary portfolio securities transactions. By writing put options, an investor assumes the risk of declines in the value of the underlying instrument and the risk that it must purchase the underlying instrument at an exercise price that may be higher than the market price of the instrument, including the possibility of a loss up to the entire strike price of each option it sells but without the corresponding opportunity to benefit from potential increases in the value of the underlying instrument. If there is a broad market decline and the investor is not able to close out its written put options, it may result in substantial losses to the investor. The investor will receive a premium from writing options, but the premium received may not be sufficient to offset any losses sustained from exercised put options. Put writing makes an explicit trade-off between up-market participation and down-market participation, while still seeking reasonable returns in flat markets. As such, in up markets, an investor typically will not participate in the full gain of the underlying index above the premium collected.

Leverage. Option overlay strategies employ the use of derivatives and leverage, which involves the risk of loss greater that the actual cost of the investment, and also involves margin and collateral requirements. Leverage magnifies both the favorable and unfavorable effects of price movements in the investments made by an account, which may subject it to substantial risk of loss. In the event of a sudden, precipitous drop in value of an account’s assets occasioned by a sudden market decline, it might not be able to liquidate assets quickly enough to meet its margin or borrowing obligations. Also, because acquiring and maintaining positions on margin allows an account to control positions worth significantly more than its investment in those positions, the amount that it stands to lose in the event of adverse price movements is higher in relation to the amount of its investment. In addition, since margin interest will be one of the account’s expenses and margin interest rates tend to fluctuate with interest rates generally, it is at risk that interest rates generally, and hence margin interest rates, will increase, thereby increasing its expenses

The NASDAQ-100 Index is a modified capitalization-weighted index of the 100 largest and most active non-financial domestic and international issues listed on the NASDAQ. No security can have more than a 24% weighting. The index was developed with a base value of 125 as of February 1, 1985. Prior to December 21,1998 the Nasdaq 100 was a cap-weighted index.

This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global- communications for the specific entities and jurisdictional limitations and restrictions.

The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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