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 Call Writing Overlays 

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.

NASDAQ-100 Index Call Writing Overlays 

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.

5-Year Beta and Correlation: Top 20 NASDAQ-100 Index Constituents3

As of December 2022

NASDAQ-100 Index Call Writing Overlays 

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.

Hypothetical Model Illustrations4

NASDAQ-100 Index Call Writing Overlays   NASDAQ-100 Index Call Writing Overlays NASDAQ-100 Index Call Writing Overlays NASDAQ-100 Index Call Writing Overlays NASDAQ-100 Index Call Writing Overlays   

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.

NASDAQ-100 Index Call Writing Overlays  

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.