Private banks, with their trust company platforms, offer special challenges for portfolio managers. Rules associated with the fiduciary requirements of trust companies can define the tools available to investment managers while common traits among bank clients can shape portfolio goals.

Prudent use of exchange-listed options and their over-the-counter clones creates new opportunities for managing risks and meeting client objectives.

Investment management within bank trust environments is typically defined by institutionalized policies and procedures. And within accounts, assets must typically be well-diversified among investment vehicles that have withstood scrutiny by due diligence teams.

While private bank clients share many characteristics with the customers of broker-dealers and RIAs, they also differ in meaningful ways. They tend to be older, wealthier, more income-focused and deeply concerned with capital preservation, often across generations. As such, their portfolios come with risk management challenges, including concentrated stock positions, low basis stock or strong emotional attachments to individual holdings.

How does this mixture of rules and client needs impact the use of options? At a minimum, the regulatory environment and trust platform restrictions generally prohibit "naked short" option strategies and similar approaches. The fiduciary approach and the conservative characteristics of private bank accounts dictate that the strategies be variations of the most conservative use of options: put hedges and covered calls. While these "plain-vanilla" strategies are well-known in the investment industry, they have interesting and often unique applications in the private bank world.

Given the risk-averse client base with a taste for income, covered call strategies often make sense in the private bank environment. However, this common strategy can be positioned in different accounts for various reasons. In the broadest application, disciplined and regular call writing against many portfolio positions changes the risk profile of an entire portfolio. Covered call strategies trade upside potential for better returns in flat or down markets. Because of their wealth, many bank clients are less concerned with maximizing returns and chasing market results, but focus rather on prudent risk management - covered call writing delivers well into that goal. Many private bank clients have a high level of sophistication and expect some benchmark of accountability.

Covered call writing also can be used to enhance the income of a portfolio. It must be noted that premiums from option sales are not considered true income from either a tax or trust accounting standpoint. The cash flow generated by option premiums and the positive returns generated in flat markets certainly provide the economic benefits of income, but the distinction can be important in the fiduciary environment.

In trust accounts with a specified income beneficiary, option premiums will not help that beneficiary unless the distribution can be governed by the Uniform Principal and Income Act (UPAIA). The UPAIA allows the trustee, within specified limits, to define trust income as a percentage of assets rather than actual income received. Although the UPAIA has been adopted in most states, portfolio managers must be cognizant of the applicable rules before considering covered call writing as an income enhancement tool for trust accounts.

The power of covered calls to create a positive return in a static market environment has many applications. In handling accounts where portfolio managers do not have full investment discretion, covered call strategies can be used to enhance the appeal of certain investments to decision makers. For example, many private bank clients find great appeal in dividend-paying equities. Unfortunately, an exclusive focus on such stocks could result in a client forgoing the advantages of low-dividend or no-dividend stocks; missed opportunities might include growth companies or much of the technology or biotech industries.

Writing calls against equities that provide no dividends can help clients accept and incorporate equities that provide no formal dividend. In an analogous strategy, portfolio managers can use covered calls to entice investors to accept exposure to non-equity assets; for example, writing call options against the SPDR Gold Trust (ticker: GLD) allows clients to have exposure to gold while turning that "unproductive" asset into an asset that produces cash flow.

Covered call writing can have portfolio applications beyond income enhancement in private bank investment management. Fiduciary environments generally require that concentrated positions be reduced or somehow managed.

Often, portfolio managers must balance the desire to reduce concentrations with barriers to taking action such as adverse tax consequences or clients with emotional attachment to the position. Writing calls against a portion of the concentration represents a sell strategy that holds the attraction of increasing current returns through option premiums and helps take the emotion out of the sell decision. Variations on this strategy could include using staggered strike prices to produce different potential exit prices. LEAP (long-term) options can also be used to increase the possibility that any recognized gains will fall into a future year, although there is no guarantee that the option would not be exercised early.

With concentrated positions, a long put hedge can be used in conjunction with the covered calls, creating the well-known collar strategy. Put hedges can have other uses within the private bank environment.

Constantly initiating an at-the-money put hedge against a long stock position is prohibitively expensive and in general makes little sense as a portfolio strategy. However, there are special situations where consistent put hedging can be considered.

When extremely low basis stock is held by a client who intends to gift that stock over time, or who is of an age where in the not-too-distant future the stock might go to beneficiaries at a stepped-up basis, an out-of-the-money put may make sense. We often look to the effective after-tax sales price as a starting point for determining an appropriate strike price.

Today's market environment puts a special burden on portfolio managers, and options represent one of the truly powerful tools to mitigate the risk in client investments.

Jeff Korzenik is senior vice president and chief investment strategist of Fifth Third Private Bank, a division of Fifth Third Bancorp.

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