Equity markets have rallied strongly over recent years. So much so that some investors are worrying about high valuations and starting to consider what actions they can take if markets turn more volatile and the danger of drawdown increases.
For a start, a defensive equity portfolio construction should reduce the drawdown compared to the broader market. And if they want to enhance the defensiveness even more, the investor can apply a covered call overlay strategy to further reduce drawdowns by taking advantage of elevated volatility levels.
Option overlays – protection on the downside
Covered call overwriting strategies systematically sell short-dated call options on portfolio holdings. The seller of a call option earns the option premium which can add an income stream to their portfolio. Furthermore, selling call options on held stocks tends to reduce the portfolio's overall sensitivity to the market, thereby helping to reduce downside risk. In exchange for the additional income and the downside cushion, the call overlay will limit the upside participation of the portfolio.
More precisely, the option premium income is a function of the underlying's implied volatility. The higher the implied volatility, the higher the premium that can be earned from selling optionality. As volatilities often spike in times of distress, selling call options tends to provide more income in turbulent market phases, thereby providing some degree of downside cushioning. For instance, during the Global Financial Crisis, option premia would have been three or four times greater, compared to a normal environment.