Talk Your Book: Hedging Your Portfolio with Options

0:00Today's Animal Spirits Talk Your Book is brought to you by Spider Rock Advisors. Go to spiderrockadvisors.com to learn how you can help your clients as an advisor to do you can help your clients to do you know your clients. and traded positions in a tax-efficient manner, hedge using options. There's tons of different options we'll talk about today. It's spiderrockadvisors.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholt's Wealth Management.

0:36This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:50Welcome to Animal Spirits with Michael and Ben. Michael, one of the themes we've been hitting on for a while now is just how important demographics is in shaping industries and spending and the economy and all these things. And with the baby bloomer generation retiring, there's going to need to be a whole suite of services provided to them in the financial services space and a lot of stuff that people just haven't had to handle in such a big, overwhelming wave of wealth before. Ben, you mentioned services. So on today's show, we speak about option trading strategies, and that's the product, but there's also the service component.

1:25So we, full disclosure, Red Holt's Wealth Management, we became clients with Spider Rock Advisors a couple of years ago to help us work through de-risking some of our client concentrated positions. And And the reason why this is such a needed product and services, the product part, we'll get into that on the show, but the service part of it, listen, we're not Chicago guys. We are not derivatives traders. And even though a covered call might seem, or just a simple protective put, might seem like a straightforward strategy, there's the trading component of it, the operational component of it, the tax component of it, the rolling component, the ongoing management.

2:02and having somebody handle that with like white glove service and be the voice piece between you and your client to come up with solutions and illustrations and all that sort of stuff goes a really, really long way. You don't want to be guessing on this stuff. Also, I could picture you in one of those like red jackets and having a smoke in between trading futures all day or whatever options in Chicago. That could have been you in another life. Camels? Who's to say? Probably, but that could have been you in another life. But yes, you're right. It's some of this stuff because I feel like we take for granted that so much can be done on a computer these days and algorithmically done and quantitative, all these rules that you can now set these days.

2:42But so much of this stuff, especially when it comes to customization, which is what clients want and need, is that the service component is a huge part of it. And knowing what you're doing, you don't want to just do this stuff willy-nilly and hope for the best. Two of the themes that we spoke about on the show today, one is customization. Certainly, Spider-Rock fits in there. And the other is advisors outsourcing things where they're not the experts. And this is definitely one of those areas. So here is our conversation with Eric Metz. Eric is the president and chief investment officer of Spider Rock Advisors.

3:15Eric, welcome back to Animal Spirits. I appreciate it, guys. It's been a while. So before we get to option strategies and how advisors work with them, congratulations are in order. BlackRock acquired the remaining equity that they did not already own. Yeah, I appreciate it. We're more than ecstatic to join forces and that deal should be closing here momentarily in Q2. Is BlackRock, well, you don't speak to this. I don't think about BlackRock as like a serial acquirer. So it really speaks volumes to what you and your team have built. Yeah. It's a good insight. Many, many moons ago when we first embarked upon the partnership with them.

3:51It was definitely a build versus buy versus partner dynamic for them, given that they have almost infinite resources over there. And so we had just spent countless hours absorbing advisor feedback and building an infrastructure and technology stack to, you know, deliver what we do with customization at scale on an after-tax basis for a very niche asset class called List of derivatives. And, you know, I think when they started to evaluate that path, it was the time invested that they couldn't replicate. And the first mover advantage that we had in the way that we configured everything to really be able to scale and deliver that value proposition.

4:30I'm curious how many people made the dad joke about the synergies of rock in the name. Had to be a lot. Everybody. Yeah. Had to be a lot of people. There were. There were many and they still continue because there's more companies that come online that have rock in the name and those jokes are not even few and far between, but weekly. So Eric, just remind the audience who maybe didn't get to listen last time, who is Spider Rock? Where did the idea come from? And how did you get to where you are today? Yeah, it stems from proprietary trading in Chicago and knowing that there are five variables in an option price and one of them can be monetized and that's the volatility component.

5:08And then, you know, as private wealth, wealth management started to evolve, as the fintech movement started to evolve, as automation came online, as the tamp arena and SMAs and UMAs, like all of those trends were in parallel at various speeds. And so combining all of them was really the genesis of me and my co-founding partnership with SpiderRock, now that being SpiderRock Advisors. And it was countless hours of adhering and appeasing advisors' demands, right? So folks that wanted to run derivatives and models, folks that had concentrated stock, folks that had clients' assets at various custodial venues, being able to incorporate that, allowing them to scale.

5:49But really, the investment works is kind of the cornerstone pillar that they're hiring us for. But the business model to solve the customization and really deliver this for practice management and scalability is kind of the cornerstone value prop that BlackRock sought. it. I'm curious for your experience in this space working with advisors, how have the advisor attitude towards using options changed over time? Have you seen a sea change there? Is it slowly, but surely you're kind of picking away at this? How has that worked for your experience? Ben, I think that's the industry movement in its totality of which we're one player.

6:22The conversations today are very different than even three years ago, let alone five or 10. I think the need for risk management has been preached from the mountaintops. There's a lot of fintech firms that have come online. You guys probably know the leaders in the space better than anybody, but they're highlighting where risk is evident in portfolios. And the adoption of models is also relevant, right? And so you get those two forces, what's the cornerstone intersection, it's tax. And so that's kind of where we sit is the cross section of all those forces. And granted, our asset class of being derivatives is super niche, which is why we don't have a ton of competitors and why BlackRock pursued us.

6:59But at the end of the day, Ben, that conversation, and I'm glad you brought it up, it's very different today than not even too long ago. I want to talk about some other dynamics that have contributed to the rise of SpiderRock and the ultimate acquisition by BlackRock. I think one of them is the bull market. And I want to come back to that. I just don't want to forget and ask this question. I'm curious, is there any cool origin story to landing your first client? There's a few. And listen, the early adopter clients, like we're, we're forever indebted and the gratitude speaks volumes. But, you know, I had a few at my old shop.

7:32I was a portfolio manager at River North Capital Management out of Chicago. And, and some of the early adopter clients are that, but I think the eyeopening experience was, um, I'll reserve their name just out of confidentiality, but it was, Hey, you're kind of pursuing an asset management vertical with a TAMP just for derivatives. And the market's not big enough for that. So you should be vertically integrated with a tamp underneath the asset management of derivative solutions. And so it was building out the infrastructure and the tech in a vertically integrated capacity that was kind of the light bulb inflection moment.

8:07And that's what the clients were seeking after, right? So advisors have many, many things on their plates. This concept of outsourcing or OCIO for derivatives started to come on our plate more and more as we were the fiduciary offering. And then when you think about the scalability, folks were using Orion or using InvestNet or using Tamarack or Redtail, and they had all these different vendors. And none of those vendors could really solve the unique work that we were pursuing. And so we decided to just keep bolting on functionality and solving it for ourselves out of necessity, frankly. But the client's feedback loop really drove that learning curve.

8:44So the reason why I credit the bull market to some of your success anyway is because clients have these legacy positions that have gone up tenfold and even larger in some cases. And there's various reasons why they don't want to sell a stock. A lot of that, it could be taxes, could be affinity or whatever the case may be. And so I'm not saying absent that you would not have had success, but there are just so many more people that hold Apple since 2013 or whatever and want Spider Rock as a solution to manage around their core holding. So can you talk about some of the use cases tied to the customization around concentrated securities with the tax-aware piece of options in mind?

9:33Yeah, listen, I don't think you're wrong in that intuition. Just let's take the MAG-7 to take the Wall Street Journal headlines and paint them in this narrative. So when folks have the definition of concentrated stock in their head, that definition is nebulous and it's different for everybody, right? So you guys could each have a million dollars of Apple and you might perceive it as too much risk on a Tuesday and not so much risk on a Thursday, right? It's kind of like what side of the bed do you wake up on for some folks? I do think one of the things that is ubiquitous in the industry as simple as covered calls and where we have taken another step further is knowing how to incorporate covered calls in that bull market to use them in a tax advantaged way, right?

10:17And so people freak out when they sell covered calls and the stock goes through the strike price. Yes, I'm going to get called away. no, you're actually not Mr. Advisor on behalf of Mr. and Mr. Client. Let's educate you as to why not. That's derivatives math. But without getting too technical, it's, hey, when we buy these options back, preventing you from being called away, we can now use it in a tax loss harvesting metric. And so this notion of direct indexing and tax managed equity has also been a trend in the industry. And so when you start to map the math, but mostly the narrative around that after tax outcome, covered calls don't become covered calls for income anymore.

10:52They become covered calls for what we now classify as strategic liquidation. And so that's one simple use case. And Vatnik, to your point on the bull market aiding that, like without the bull market, that tax picture, yes, it's there, but covered calls are income. It's reframing income into strategic financial planning. That's the crossing the chasm and the education that we've taken and evolved. And a lot of that's just data and infrastructure. Being able to do that at scale is, I can have the conversation, but operating it, conversing around it, having the collateral to disseminate and aid a lot of our clientele is cornerstone to the success.

11:29And that's just one use case, and there's many. So the bull market has definitely contributed. And what I think it's done mostly is highlight what I'll call the drift phenomenon, right? So even if you're direct indexed into the market, when you own SPY or IVV or VOO, you don't see that concentration. When you own those individual securities and you see them in video just flying off the charts every quarter, like that, that grabs your attention and it forces a conversation. Do you think that the covered call strategy, as far as options go for people who aren't in the option space all the time, is that the easiest one for people to grasp?

12:04Because my sense is Michael and I get a ton of questions on covered call strategies. And because it's essentially, like you said, an income product at its heart, is that easier for people to grasp when they're trying to get their head around these things? I think it's the most ubiquitous use case because it's the one that's conventional for advisor education, like rewind the clock into the early part of your careers. Everybody's taught that. I don't think it's the easiest to understand because of that tax picture that I just outlined and the real value prop that it delivers. I think the easiest to understand is the insurance metaphor, which is the opposite, right?

12:36So a protective put is, I don't want to call it the inverse, but it's pretty close, right? It's taking your thousand shares of Apple and buying 10 puts. And everybody has insurance on their home or insurance on their car. Some even have insurance on their life, but their concentrated stock, which is arguably their largest asset, they don't have insurance. Why? Because it's often cost prohibitive. Well, if it's cost prohibitive, then can we flip that inversely into using it for their advantage? That's covered calls. That's the income component. And so it's the intercombination of this with financial planning that we've really found ourselves working with advisors on solving unique investment problems that derivatives, frankly, are the only asset class that can solve them.

13:20But, you know, covered calls, I think, are often misunderstood. I think protective puts are an easier conversation because it's uniformly aware in folks' lives. I'm curious when you're putting these positions on, how much do you have to care about the current market environment? Because obviously option pricing can change based on volatility and the price of the underlying security. So I'm curious how tactical you get in overlaying some of these strategies where you say, listen, the protection of this asset makes way more sense. We've got to do this now versus being more tactical, understanding the pricing based on the market dynamics.

13:53It's a little bit of both. I would say Spider-Rock Advisors is never going to take a tactical stance on the market or on the direction of a securities price. So NVIDIA, MAG7, valuations, inflation running hot, Fed decision-making policy, we're going to absorb that in our client's lens and incorporate it to applying the right solution set from where we sit. That being said, we will have a stance on where the volatility surface is providing value and where relationships within the volatility service should be outlined and discussed. So low vol environment, insurance is cheap. High vol environment, income is likely more probable or more appetizing.

14:36That's just the difference between protective puts and covered calls, respectively. But I think what you're highlighting, Ben, is our work we view as a core allocation. We view it as improving better investment portfolios, both pre-tax and after-tax. But the unique piece of our asset class that is, I'll call it extremely coveted, is the ability to have more predictable outcomes and have defined utilities of each investor. Each investor could have the same exact suitability in their questionnaire, could have the same exact portfolio, could have the same exact estate plan, net worth, income, etc.

15:09But their risk aversion will dictate often where our work is better suited for them. And advisors gravitate towards what works for them in their practice. So we're not one size fits all with a strategy. This is very bespoke to clients, but probably more bespoke to an enterprise or their advisors. There's clearly a large amount of demand for these sort of cover cost strategies. If you look at just the ETF market, JEPI is the largest active ETF in the world, I believe. And it's a cover cost strategy. There's a few threads to pull from that. One is the growth of the entire industry, regardless of wrapper and ETF versus an SMA versus a mutual fund.

15:56There's another dialogue around like the tax efficiency and the customization that SMAs would predominantly have an advantage over the ETFs. But at the end of the day, I think there's one common theme that has two main trends. One is the demographic of private wealth. We all know where the baby boomer generation has amassed their trillions of dollars of investment portfolios and where we sit today and almost even off 5%, we're still at nominal highs. And so these strategies have an element of risk management. So the natural retirement playbook is to downshift equity risk. And so I think there's a cornerstone theme in the demand for all of these instruments, wrapper agnostic.

16:38I think the other component to this is when advisors look at ETF solutions or mutual fund solutions or direct indexing or tax managing solutions, like there's a there's a value proposition that goes up and down the food chain of of the quote unquote wrapper. And I think where we're slotting in and where we're seeing a lot of our clients gravitate is really around the value prop of incorporating this in your after tax components. Right. If I have a ticker, yes, it's tax efficient, but the ticker is the vehicle. So with an SMA and where we're operating, you know, the value prop of the investment of hedging and volatility management is still there.

17:14That can be, you know, parapersu. It's really around the after-tax outcomes and delivering that customization. So it takes a little bit more education and focus from an advisor or their clients. But at the end of the day, the value props start to come through in those second and third order dialogues. So I think that the customization piece is huge for advisors. And you mentioned working in concert with direct indexing. And I think that's probably one of the misnomers there is that people assume, well, technology takes care of it, so it's easy. But we know firsthand that managing that sort of SMAs in a direct indexing platform, you have to have advisors and operations, people that know what they're doing.

17:49So your team at SpiderRock is working hand in hand with advisors to figure out, okay, we have these tax exposures and tax loss harvesting on direct indexing. How does that work in concert with the options? How does your team pull that off? Yeah, it's evolving. I mean, it's frankly, I think the quest of what we're seeking to do with BlackRock now on the other side of the acquisition is really solving for the easy button. Right. It's like how do advisors scale this? And it takes resources. It takes collaboration. And frankly, up until now, from where we sat, we were just the options vertical. So I'm always agnostic to everything at the underlying portfolio, whether it's mutual funds, whether it's models, whether it's direct indexing.

18:29And what I think the industry and advisors have told us this is solving for this in one account, right? Call it the whole portfolio, right? You have your asset allocation strategically defined by an advisor, maybe a home office CIO, maybe consultant, whatever the enterprise dictates on behalf of a client and their suitability. But now they need to operate and scale it. And so now the more after-tax components you weave in, the more data synchronization you need. And so this is where the industry is going and what I think we're attempting to solve with my new partners at BlackRock around the whole portfolio and all asset classes with us just being the derivatives component of it.

19:11So that's the biggest challenge we see, but also the biggest opportunity. Do you find yourself working with advisors on the behalf of clients more to solve the concentration risk issues around some of their securities or at the portfolio level as a whole? This varies by, I'll call it the life cycle of my client. Every client of ours uses us for concentrated stock. We don't have a single client that's ever come on board that we've never addressed one unique client instance. What I think happens though, Michael, as folks start to get more immersed in our work and they start to have not one, but 10 clients, not 10, but 20, all of the stuff at the portfolio level becomes relevant, right?

19:53The biggest barrier to entry here is operations. It's not investments or investment know-how. And so when you think about dedicating the time for somebody with $25 million of concentrated stock of Apple, that same application can now be applied to a portfolio of low basis things. And so this goes back to our earlier conversation around what is a concentrated stock, it's just a low basis something. And so we always like to frame that dialogue with, you know, Mr. Advisor on behalf of Mr. Mr. Client, like if taxes were zero, what would you do? You start getting real interesting conversations that come up and how our work can provide value.

20:30I don't want to get into like the nitty gritty IRS stuff, but like what are some of the main benefits tax wise when it comes to trading options? I think the biggest is being able to reshape the risk in a portfolio and not incur an instantaneous friction of capital gains liabilities, right? So take your 80-20 client who just entered retirement. If there were no tax frictions and they didn't have any qualified accounts to de-risk any equities, then selling those equities right now would probably force a tax conversation. So if I can synthetically do that, selling calls, buying puts, whether it's an Apple, Amazon, NVIDIA, or the S &P, or frankly, on mutual funds regressed into the S &P, then I've instantaneously solved the investment objective with no tax friction.

21:12And so that conversation is evident in a concentrated stock. It's less evident in a portfolio construct. But folks, the more they work with us, start to see the power of that math really working for them and their clients. Right. So that glide path, I need to go from 80-20 to 70-30 or 60-40, do it when we're using options instead of selling 10 % to 20 % of my stocks. Bingo. That's it right there. And that really scales for folks. and we can take it a step further into what I'll call a risk transfer. We had clients last week trying to, as the growth and the momentum showed some evidence of potentially unwinding, let's take my growth and go to value.

21:52We've been waiting for this. I don't need to get any greedier in this factor. Let's downshift growth and start to insert value. And derivatives can do that almost instantaneously. How does a current interest rate environment impact these strategies? Um, we get this question a lot. So options instantaneously reflect, reflect the financing of all risk-free rates. Um, that's how options are priced. And so unless you're trading really long dated options, like two, three, four years, there's no equivalent duration element to them. Um, it's an options variable called road to get technical, but like, it's, I don't want to say it's moot.

22:31Interest rate volatility spawns over into equity volatility. So volatility is present there. But the actual interest rate sensitivity for our work depends on strategy. But for a lot of the strategies, if we're inside of a year and their maturities, I don't want to say irrelevant, but it's not a focus. So it's almost like the borrowing and the lending component cancel each other out, essentially, right? Is that the way we're looking at it? Is that a net impact? Um, it has more to do with the fact that all the market making community is pricing in interest rates into their models instantaneously as they're, as they're moving around.

23:05And that flows through to the exact mark to market price of each individual option. And so if you're levered, that's a, that's a, something that you're going to want to focus on, but none of our work is levered, right? A thousand shares of Apple, they're getting 10 short calls. If those calls are in two or four months, the interest rate sensitivity to that client's portfolio for those options is, I don't want to say de minimis, but it's low. That's true. That makes sense. I have a two-part question. Is there, I know there is, talk about the threshold of a company's size at which you guys operate.

23:38And then part two to this question would be, let's say that somebody has, let's say that hundred million dollar position and a stock that has a two and a half billion dollar market cap. Like it's, it's a lot. Can you potentially help make a market? Let's bite those off one at a time, given your two part framework. Number one, the size of the security is really whether or not there are options listed, which is an industry standard regulated kind of set of criteria that, that each company must meet to be listed on the exchange and then to have options listed subsequently thereafter. So we're just going to follow those.

24:20The next piece of your question is founder with respect to what size of the float or what percentage of the float they are, can we make a market? Yeah, in other words, if there weren't listed options, is there anything that you can do to help somebody with a really concentrated position where it's like working directly with market makers? I'm talking out of my ass. I don't know if this is like a real thing. Yeah, no, I get, we get this a lot. We will never make a market. Number one, we're always a fiduciary to our clients. That's, that's the first point. The second point, we can petition and lobby on their behalf to the exchanges to get options listed, but they still have to go through the set of criteria.