Creating Client Income with Equity Options with Michael J. Egan

And today we have with us Michael Egan, who's the president and CIO of gyroscope Capital Management. gyroscope specializes in providing low volatility, equity income, and custom hedging solutions. Michael, welcome.

Michael Egan  00:39

Oh, thanks for having me. Doug, you know, I, I have been very fortunate in my career. My Investment Management career started in 1990. On Wall Street on an institutional fixed income derivatives desk, we helped fortune 25 companies like American Express and Ford Motor, reduce their bond interest costs, by swapping fixed rate bonds for floating rates, or the reverse, depending on which was more cost effective. And what I quickly learned is that options can be applied in three very different ways. And that this is equally relevant for individual investors. First, an investor can hedge or protect ownership in some underlying position with options like concentrated stock, for example, number two, an investor could sell options to generate income. And we're going to get to a lot of that in a few minutes. And number three, of course, an investor can speculate with options. This is absolutely not what we do. Doug, basically, I found a gyroscope in 2006, to provide investors with access to hedging and equity income, because I realized how impactful these strategies could be, and that there really weren't a lot of other firms that were offering these strategies. You know, Mike, I'm glad you mentioned income. We hear regularly from advisors that finding income for their clients is a growing challenge.

Douglas Heikkinen  00:42

You've had such a successful career in financial services. And then you started gyroscope. Why'd you start?

Michael Egan  00:50

Doug, you know, I, I have been very fortunate in my career. My Investment Management career started in 1990. On Wall Street on an institutional fixed income derivatives desk, we helped fortune 25 companies like American Express and Ford Motor, reduce their bond interest costs, by swapping fixed rate bonds for floating rates, or the reverse, depending on which was more cost effective. And what I quickly learned is that options can be applied in three very different ways. And that this is equally relevant for individual investors. First, an investor can hedge or protect ownership in some underlying position with options like concentrated stock, for example, number two, an investor could sell options to generate income. And we're going to get to a lot of that in a few minutes. And number three, of course, an investor can speculate with options. This is absolutely not what we do. Doug, basically, I found a gyroscope in 2006, to provide investors with access to hedging and equity income, because I realized how impactful these strategies could be, and that there really weren't a lot of other firms that were offering these strategies.

Douglas Heikkinen  02:06

You know, Mike, I'm glad you mentioned income. We hear regularly from advisors that finding income for their clients is a growing challenge.

Michael Egan  02:15

You know, it really is we completely agree with you, we perceive that there are actually two challenges facing investors and their advisors. The first is a lack of alternatives to generate income. Now, most advisors and their clients have historically considered fixed income as their primary income source. But does anyone think that mindset still works with interest rates near all time lows? And in fact, we all know that bond interest rates are multi decade lows, for example, the 10 year US Treasury is we're talking is below 2%. This is why we believe now more than ever, that equity income solutions that can provide a consistent 6% income are critical to consider as a complementary traditional equity and fixed income portfolios. Let me ask those advisors on the listening. Even if interest rates recover in the next few years, can investors realize sufficient income? For example, if the 10 year US Treasury rises to two and a half, or 3%? Will that be sufficient? The second challenge, Doug that we perceive is demographic. There's a great study recently by the Pew Research Center, and it elucidates that baby boomer retirees have increased by 3.2 million Americans in 2020. So 3.2 million Americans in 2020 alone. Presumably a large proportion of these retirees now need to take income from their investment portfolios to replace their wage income and investor seeking consistent income of more than 5% annually to meet their spending requirements. This would include individuals foundations and endowments, pensions, etc. Without using significantly riskier assets may benefit from considering deriving some of their income from equities with dividends and covered call premiums.

Douglas Heikkinen  04:15

Okay, before we talk about gyroscopes strategies that help investors generate income using options, can we briefly review how options work? I mean, I remember options on the series seven test. And maybe many of our listeners are familiar with options but might not use them on a daily basis. Give us some education.

Michael Egan  04:35

Absolutely. An option we all remember is the right but not the obligation to buy or deliver the underlying. In our case, the US public stock, the seller of the options and of course our team does this for the benefit of the adviser in the investor receives the option premium when you are the seller. When we use options to help a client hedge or protect an existing holdings We're both buying a put option on the client stock and simultaneously selling a call option on that same stock. When we use options to help a client generate income and one of our covered call portfolios, our portfolio management team selects the stocks we buy for the portfolio, and thus the stocks upon which will sell covered calls.

Douglas Heikkinen  05:24

That's great. Thanks for the refresher on options. Can you tell us more about how investors can derive income from equities

Michael Egan  05:33

Sure, for those investors seeking income, which is a large part of any advisors clientele, we would suggest that they consider selling covered call options. And this is a fairly straightforward exercise, our team identifies our preferred option for each security, and then typically enters limit orders to make sure that the trade execution is to our satisfaction. Remember that for many large cap stocks, there can be hundreds of option contracts. So selection of each option can involve considerable analysis, it's important to note that the first step is to identify and purchase the underlying securities for the covered call sales. That's the covered part. Our team of portfolio managers invest a large portion of their time into security analysis, which includes both factor screens and fundamental valuation. And Doug course, it's beyond the scope of today's call to review our security selection process. But if any of our listeners are interested in the process, we're happy to walk you through it over zoom, or we can send you our process via email.

Douglas Heikkinen  06:39

So are there different strategies for clients with higher income needs versus moderate income needs?

Michael Egan  06:46

There are in fact, we offer three slightly different equity income solutions for exactly that reason. The first is our US large cap value stock strategy, which we call dividend income or internally di. It has an annual income target of 6%. That's comprised of roughly 3%, dividends, and 3% covered call premiums for a course a total of 6%. This strategy may be appropriate for those investors seeking higher income. dividend income benefits the investor in three very different ways. First, using a proprietary quantitative stock selection model, our team identifies us large cap value stocks with meaningful upside potential. Second, consistent income generation as I just mentioned, 6%, annualized from both dividends and cover call sales. And finally, sector and industry diversification. We maintain sector weights within plus or minus 5% of the s&p 500 sector weights. In other words, we're taking a very limited sector bias in that portfolio. The second strategy which we call growth in income, not surprisingly, invest in us large cap growth stocks, and it's appropriate for investors seeking capital appreciation but who also desire the income afforded by cover call premiums. This strategy would be suitable for investors seeking more moderate income. The growth and income portfolio seeks capital gains by investing in companies we identify as having above average growth prospects supplemented by the call of cover the sale of covered call options. And finally, our third strategy, which we call the s&p 500 optimal weight portfolio is a US large cap core strategy. It offers capital appreciation and again covered call premiums. The goal of optimal weight, as we call it internally, is to overweight or underweight each of the 11 guix sectors of the s&p 500 to provide outperformance versus the benchmark. We also opportunistically sell covered calls to generate premium income.

Douglas Heikkinen  09:05

We certainly hear you that equity income is an important category worth considering. And there are other equity income solutions out there that employee covered calls. How is gyroscopes approach different?

Michael Egan  09:18

No, we do three things that are in our opinion, differentiate us from many of our competitors. First, we write our covered calls, not on the indexes, but on the individual positions. In other words, the underlying stocks within our portfolios. Most investment managers won't take the time to do this. We feel that by writing options on the underlying equities, the investor benefits from higher option premiums when compared to index options. Second, most managers are relatively concentrated. That is they are biased towards a handful of the gig sectors. We believe that a portfolio weighting which is closer to the s&p weighting, especially for our dividend income strategy, supports our risk management And finally, most other managers are excessively diversified, in our opinion at the security level, and gyroscope, we believe our mandate is to add value, and that concentrated portfolios can more effectively deliver value.

Douglas Heikkinen  10:15

So shifting from equity income to how gyroscope capital can help an investor has too much of a good thing. In other words, too much of one stock? how can how do most investors come to own too much of a good thing? When what can they do about it? How can gyroscope help

Michael Egan  10:33

it, Doug, this is a big shift. So for those listening to the podcast, we're now moving from underlying portfolios that are designed to generate income where the advisor and the client invest cash with us and our team purchases individual securities pursuant to our security selection process, and then sells cover calls on them. This is very different. This is where the client has too much of a good thing. They either worked for a company and amassed a great deal of underlying company stock, they might have done that through employer issued stock options, or just participated in the stock purchase plan for many, many years, they might still be an employee that might be a retiree. Other clients come to us or investors come to us because they sold their private business for public company stock. Others are really good investors. They purchase stock 10 1520 years ago, or in some cases 10 or 15 months ago, and have had enormous price appreciation. They don't want to sell the stock. But they also don't want to take the risk of it falling back to where they purchased it. And finally, we have some clients who just inherited a lot of stock and also want to protect it. There's a lot of sort of mainstream ways that investors come to have too much of one stock. You might say, Well, that sounds like a pretty pleasant problem have too many shares in one stock. But indeed, it is a challenge. If that ownership of that stock makes up more than half of an investor's net worth, then any issue with that company or that particular issuer, whether it's a market driven event that drives the price down or a company specific event that drives the price down can really impact a client's financial or estate plan. And in fact, other items that clients tell us they're concerned about are how do I defer my taxes on this enormous potential gain? I've got in this particular stock holding, how do I access liquidity? If all I own is stock? How do I protect the asset? How do I diversify? How do I effectively plan for my estate? These are all excellent questions, and important that we can help solve the first question, which is, how do I protect that asset? While defer deferring taxes on the underlying security? And that adds a little bit of a wrinkle. You may remember Doug, the first several questions here we chatted about selling covered calls. And of course that generates income. When you own a single stock, your most important concern should be to protect that stock from going down, of course, to do that, we create customized options that are customized specifically to the investment investors objectives. And we execute those such that they can be deposited into the client's custody account, they're assigned to CUSIP by the Chicago Board options exchanged. So they are a publicly traded security, although typically they don't trade because they're so customized. So step number one is identify the clients objectives. How long do I want to defer any particular sale of the security do I want to employ a financial plan, where I might sell 10% of a very large holding over 10 years 10% per year, for example. So step number one is create a put option or floor or lower limit, where if the stock goes below that particular strike price, we may remember that from from the options test we all took many years ago. If this share price goes below the strike price, then the investor really doesn't participate below that stock price anymore. They have the ability to sell the stock or put it or they can cash settle that put, it's really important to note that each step we take in creating a customized hedging strategy is best followed via a financial plan. In other words, it's a good idea to know where you want to end up before you start. So step number one is create a put option. One of the challenges with buying a put option, however, is that you have to end To premium, and over time those premiums can add up. One way to mitigate that cost is no surprise Doug, to sell a customized covered call option, or a ceiling or a cap on the same stock for the same term the same number of days or months or years. And on the same number of shares, here's what the customization can really help for clients. Number one, we specify the exact maturity date, number of shares, etc. But number two, when I sell that cover call, or when our team sells that cover call, we're going to structure that call, so that the income received from the covered call exactly offsets the cost of the put. In layman's terms, the sale of the ceiling exactly offsets the cost of the floor. And the combination of those two, the purchase of that floor, and the sale of that ceiling or cap. That's a collar, just like the color on your shirt. If the cash flows exactly offset, as I just described, then you've got what's called a zero premium or cashless collar. And it's really important note, it's not free, you're giving up upside in that collar beyond your cap. Let me give you a quick example, if I may, let's assume that the client owns a particular stock worth $100. Let's make the math easy on all of us, especially me. And the client says, You know, I really don't want to watch this stock go below $85. I think it has some upside left. I really want to continue to to own it. But I don't want to see this stock go below $85. Well, that would be the level where we would invest in a put option, we create that floor for the clients position. In order to pay for that floor. We might sell a ceiling or a cap at $110 as long as the income or the premium received from that $110 cap exactly offsets the $85 floor. Then we've got a collar which is a zero premium. We're cashless collar. One last point, Doug, is that we tend to renew or reset or rollover these collars. Every time they mature until the clients investment objectives are met. And often that can be a multi year process.

Douglas Heikkinen  17:26

Michael, this has been absolutely enlightening. If people want to learn more about gyroscope, where should they go?

Michael Egan  17:34

We're excited to help advisors learn and use equity options both for income generation and for concentrated stock hedging. Now, our team knows that most advisors don't use options every day so we really like serving as the advisors partner. We're available to join a call or zoom to explain how options work with investors via their advisor. Please call us or visit gyroscope capital calm.

Douglas Heikkinen  17:58

Thanks, Michael.

Michael Egan  18:00

Thanks, Doug.

Douglas Heikkinen  18:02

For everybody and advisorpedia our producer Jakie Beard and the power your advice podcast team. This is Doug Heikkinen

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