Investors strategically and thoughtfully choose target weights for their portfolio asset allocation. As asset values fluctuate, the portfolio becomes overweight the winners and underweight the losers relative to the long-term strategic target weights. This cross-asset momentum effect introduces unintended tactical risk and tracking error to the portfolio. Portfolio managers should seek to optimize the portfolio rebalancing necessary for portfolio weights to return to the intended long-term risk exposures that are explicitly constructed and sized.

The short option overlay strategy entails selling a range of (initially) out-of-the-money strike prices that force systematic rebalancing of the underlying portfolio as the underlying S&P 500 Total Return index moves. At expiration, an investor who has sold out-of-the-money options that are in the money is obligated to sell (buy) shares as the short call (put) options are exercised. The greater the index movement, the greater the number of shares that are sold (purchased).

A short option overlay helps hedge unintended timing risk and forces systematic rebalancing. The authors also find that a bond and equity portfolio exposed to momentum between rebalances detracts from performance, which reinforces the empirical evidence that trend following is more effective over the long term.

The strategy requires only a small notional number of options to be sold because the primary goal is minimizing tactical equity exposure rather than harvesting volatility risk premiums. The option premiums received, which are expensively priced on average, help offset transaction costs and provide a small source of alpha to the portfolio.

Key components of this strategy are the European-style settlement (i.e., only at option expiration), utilization of physically settled options, and the ability to manage the additional operational complexities, not the least of which is the requirement to carefully account for options that were previously sold when selling any new options.

The option overlay works well when equity exposure is a broad exchange-traded fund or passive index and physically settled options can be used to directly rebalance the portfolio weights. Cash-settled options may be suitable when equity exposure is individual stocks and an investor does not wish to liquidate holdings because of taxes, illiquidity, or other considerations.

A sample portfolio and policy benchmark consisting of 60% equity and 40% fixed income is constructed using the S&P Total Return Index and Barclays US Aggregate Bond Index as the only two holdings. Bloomberg provides historical return information for these indexes as well as for LIBOR, which is used as the risk-free rate in the Black–Scholes calculations. The OptionMetrics IVY database provides closing bid–ask spreads and deltas on S&P 500 Index options. Monthly rebalancing, daily rebalancing, and option overlay strategies are compared over a 20-year backtesting period from 1996 to 2015. The authors run 10,000 simulations under a lognormal distribution with 16% annualized volatility for stocks and 4% for bonds. Options are priced using the Black–Scholes model with 16% implied annualized volatility.

The option overlay is constructed by selling calls and puts with a relatively small notional amount. The small notional amount of options sold supports the primary objective of rebalancing and hedging. As the target weight to equities increases, less rebalancing is required; for example, a 100% equity portfolio requires no rebalancing.

The range of tactical equity exposure was significantly narrower for the option-overlaid portfolio, ranging from –1.0% to 0.9%, compared with –7.6% to 2.9% for the standalone portfolio. The option overlay portfolio is largely neutralized to equity returns between rebalances, with the residual tactical equity exposure resulting from the options’ delta not perfectly offsetting the standalone portfolio’s tactical equity exposure on the days just prior to option expiration.

The option overlay strategy produces 11 bps of annualized excess return and 26 bps of annualized volatility. This performance is decomposed into delta-neutral and tactical equity exposure components. When the option premiums received are netted against trading costs, the overlay produces a net positive 5 bps of alpha for the portfolio, whereas monthly rebalancing costs 0.3 bp and daily rebalancing costs 1.3 bps annualized trading costs.

The magnitude of the market movement in any given month is unknown at the time the option overlay is constructed, but selling a range of options effectively increases the number of shares rebalanced as larger market movements occur. Including short-selling options in the portfolio might bring an undesirable level of asymmetrical tail-risk exposure. If markets significantly decline, the loss to equities is amplified by rebalance buying at strike prices above the current market price. If markets significantly gain, the return on equities is tempered by rebalance selling at strike prices below the market. The option overlay may enhance returns in periods of low to moderate market movements but should underperform when large, sudden market movements occur in either direction.

An option overlay reduces tactical equity exposure but is not a perfect hedge because of option deltas changing over time. More-complex rebalancing strategies—for example, including futures or dynamic rebalancing using current option deltas—may better hedge tactical exposure. Variance swaps do not help with rebalancing because they are delta hedged and cash settled.

Although systematic rebalancing is preferred, investors must still exercise discretion in constructing the overlay—the intervals and range of strike prices sold, the notional amount hedged, and the minimum premium threshold. As farther out-of-the-money options are included in the overlay, the diminishing premiums received may barely compensate for transaction costs and added tail risk. Ultimately, including an option overlay pays for itself and adds alpha to the portfolio, but investors may choose target allocations according to risk-based methods or have other real-world constraints to consider before implementing an overlay.