Cooper Rey and Brandon Laczkowski, Vice Presidents of the Global Markets Division at Goldman Sachs, explain three strategies that provide clients with downside protection and liquidity solutions: covered call writing, collar, and prepaid variable forward (PVF).
Rey explains that these strategies may be a good fit for clients with large low basis positions, large amount of their net worth tied in a single stock, and clients working for hedging strategies with no upfront cost or premium paid, as well as clients looking for liquidity or to diversify risk away from a single stock, including those who may already be using margin lending on a concentrated position for liquidity.
The first strategy is covered call writing, which is a private contract between two parties where the client receives an upfront premium in exchange for being willing to forego upside on a stock above a certain price for a specified period of time. This strategy can be used to create or increase yield on an equity position, or to liquidate an equity position and take in premium while waiting for the stock to reach this level. An important consideration to covered call writing is that though the premium received is not taxable at time of receipt, the client retains downside exposure to stock beyond the initial premium received.
The second strategy is a collar strategy, which is a hedging strategy where the client buys a put to protect against declines below the put strike in the underlying shares, and it funds the cost of that put by selling a call and giving up any gains in the underlying shares above the call strike. The client retains the flexibility to select put and call strike levels to meet their desired payoff profile, and this provides the client certainty on exactly how they’re protected on the downside.
The last strategy is the prepaid variable forward (PVF). PVFs, designed to diversify underlying risk, have not been widely accessible to the RIA market until recently. A prepaid variable forward starts with a collar and is married with a loan package. A PVF offers stable high loan-to-value (LTV) liquidity against a collared share position. This provides several advantages to the client: the client has the ability to raise stable liquidity for a declined period and maintains exposure to the underlying shares for appreciation in the stock up to a stated level. At maturity, the client may elect to settle the PVF physically or in cash.
All three strategies have important risks to consider, alongside their benefits. Covered call writing, collar, and prepaid variable forward (PVF) strategies are designed not to trigger current tax on underlying shares and allow the client to retain dividends and voting rights on those shares.
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