Overlays in Trading

Overlays in trading involve adding specific strategies or positions to manage risks or improve returns without taking away from the core holdings of the portfolio.

Overlays can be applied to various aspects of financial markets, including currencies, volatility, commodities, and more.

Key Takeaways – Overlays in Trading

• Risk Management – Overlays allow better precision in exposures and risk control without disrupting core positions. Enables traders to hedge specific exposures or adjust portfolio risk dynamically.
• Flexibility – Traders can quickly adapt to market changes using overlays, fine-tuning strategies without wholesale portfolio restructuring.
• Performance Optimization – Overlays offer opportunities to boost returns through targeted exposure to factors, themes, market inefficiencies, etc., not captured by the core portfolio.

How Overlays Enhance Portfolio Management

Exposure Without Core Asset Disruption

• Selective Targeting – Overlays allow targeting specific risks or opportunities without altering the core portfolio’s asset allocation. For example, if a trader wants 15% of a stocks/bonds portfolio in gold, they don’t sell 15% of the portfolio in the stocks or bonds to buy the gold.
• Flexibility – Traders can quickly adjust their exposure to certain factors (e.g., currencies, volatility) without buying or selling the underlying assets.

Risk Mitigation and Return Enhancement

• Risk Diversification – Adding overlays can diversify risk sources, reducing overall portfolio volatility.
• Additional Income – Strategies like selling options (volatility overlays) or currency hedging can provide additional income streams.

How Overlays Are Constructed in a Portfolio

Overlays are implemented in portfolios through various financial instruments and strategies.

Common methods include:

Derivatives

Using futures, options, or swaps to adjust exposure.

The amount of collateral required relative to the exposure they provide is low, which makes them attractive for use as overlays.

ETFs

Adding sector or thematic ETFs for targeted exposure.

Short-term trading

Using tactical trades alongside long-term positions.

Systematic strategies

Applying rules-based approaches to dynamically adjust positions.

Hedging instruments

Using put options for downside protection.

Synthetic positions

Creating exposures through combinations of derivatives, through various trade structures.

Separate managed accounts

Dedicating a portion of the portfolio to specialized overlay strategies.

The specific implementation depends on the overlay type, portfolio objectives, and markets.

Currency Overlays

Currency overlays involve managing currency risk separately from the underlying investments/trades in the portfolio.

This is important for portfolios with international exposure, where currency fluctuations can impact returns.

When a US-based trader is trading European equities, for example, it’s not just the changes in the stock that matter, but also the currency effects.

Purpose and Benefits

• Risk Management – Hedge against adverse currency movements.
• Enhanced Returns – Exploit currency trends for additional gains.
• Example – A portfolio with European equities might use a currency overlay to hedge against the euro weakening against the USD if they own EUR-based assets.

Volatility Risk Premium Overlays

Volatility risk premium overlays involve strategies that capitalize on the difference between implied and realized volatility.

Typically, this means selling options to earn the premium that buyers are willing to pay for protection, but could also mean the opposite depending on the analysis and circumstances.

Purpose and Benefits

• Income Generation – Earn premium income by selling options.
• Risk Reduction – Manage exposure to market volatility.
• Example – A fund might sell S&P 500 index options, collecting premiums as a form of income, assuming realized volatility will be lower than implied volatility.

Related: VRP Overlay Strategy

Commodity Overlays

Commodity overlays add positions in commodity markets to a portfolio, either for hedging purposes or to gain exposure to commodity price movements.

Sometimes they’re used as an inflation hedge.

Purpose and Benefits

• Diversification – Reduce portfolio risk by adding uncorrelated assets or at least ones that do well in a particular kind of environment (rising growth and rising inflation).
• Inflation Protection – Commodities often serve as a hedge against inflation.
• Example – An overlay might include futures contracts on oil or agricultural products to protect against inflation or to benefit from anticipated price increases.

Alpha Overlay on Beta Overlays

Combining alpha and beta overlays involves separating the portfolio’s returns into market (beta) and active management (alpha) components and then applying additional strategies to enhance each.

Purpose and Benefits

• Enhanced Returns – Use active management (alpha) strategies to outperform the market.
• Risk Management – Use passive strategies (beta) for broad market exposure.
• Example – A core portfolio of S&P 500 stocks (beta) combined with a long/short equity strategy trying to outperform the index (alpha).

Interest Rate Overlays

Manage interest rate exposure separately from the underlying fixed income investments.

Purpose and Benefits

• Hedging – Hedge against interest rate risk or take advantage of interest rate movements. Swaps and bond futures are common.
• Example – Using interest rate swaps to manage the duration of a bond portfolio.

Credit Overlays

Focus on managing credit risk within a portfolio of bonds.

Purpose and Benefits

• Direction to Credit Risk – Protect against or benefit from changes in credit spreads.
• Example – Using credit default swaps (CDS) to hedge against defaults in a corporate bond portfolio.

Equity Overlays

Equity overlays involve using derivative instruments to gain or hedge exposure to specific equities or equity indices without directly holding the underlying stocks.

Purpose and Benefits

• Tactical Adjustments – Quickly adjust equity exposure based on market views.
• Risk Management – Hedge against potential downturns in the equity market.
• Example – Using equity futures or options to adjust the beta of a portfolio or to protect against market declines.

ESG Overlays

Environmental, Social, and Governance (ESG) overlays involve integrating ESG criteria into investment strategies to align portfolios with sustainability and ethical standards.

Purpose and Benefits

• Responsible Investing – Align trades with ESG values and objectives.
• Risk Reduction – Address long-term risks related to environmental and social issues.
• Example – Implementing a negative screen to exclude companies with poor ESG ratings or using derivatives to adjust portfolio exposure.

Inflation Overlays

Inflation overlays are strategies designed to protect the portfolio from the eroding effects of inflation.

Purpose and Benefits

• Inflation Protection – Hedge against rising inflation which can erode purchasing power.
• Diversification/Unique Portfolio Exposure – Include assets that typically perform well during inflationary periods.
• Example – Using inflation-linked bonds (e.g., TIPS) or commodities as part of an inflation overlay strategy.

Tail Risk Overlays

Tail risk overlays involve strategies aimed at protecting the portfolio from extreme market events or “black swan” events.

Purpose and Benefits

• Extreme Event Protection – Hedge against rare but severe market downturns.
• Improved Portfolio Stability – Improve overall portfolio stability by reducing the impact of extreme market fluctuations.
• Peace of Mind – Provide a safety net during periods of market stress.
• Example – Purchasing deep out-of-the-money put options or using structured products designed to pay off during extreme market drops.

Duration Overlays

Duration overlays are used in fixed-income portfolios to manage interest rate risk by adjusting the portfolio’s duration.

Purpose and Benefits

• Interest Rate Risk Management – Hedge against adverse movements in interest rates.
• Yield Enhancement – Take advantage of expected changes in interest rates to improve returns.
• Example – Using interest rate swaps or futures to lengthen or shorten the duration of a bond portfolio.

Sector Overlays

Sector overlays involve tilting the portfolio exposure toward or away from specific economic sectors.

An example would be a trader pushing more of the portfolio toward consumer staples or utilities for a more stable performance.

Purpose and Benefits

• Sector Rotation – Capitalize on expected outperformance or underperformance of certain sectors.
• Risk Management – Reduce exposure to sectors perceived as risky or overvalued.
• Example – Using sector ETFs overweight and underweight certain sectors based on economic outlook.

Liquidity Overlays

Liquidity overlays try to make sure there’s sufficient liquidity in the portfolio to meet obligations and take advantage of market opportunities.

Purpose and Benefits

• Liquidity Management – Maintain adequate liquidity to meet redemptions and other cash needs.
• Opportunistic Investing – Have liquidity available to capitalize on market dislocations.
• Example – Holding short-term instruments like Treasury bills or using liquidity-focused ETFs.

Credit Quality Overlays

Credit quality overlays involve managing the credit risk within a portfolio by adjusting exposure to different credit qualities.

Purpose and Benefits

• Credit Risk Management – Reduce the impact of deteriorating credit conditions.
• Yield Optimization – Enhance yields by selectively increasing exposure to high-yield securities.
• Example – Using credit default swaps (CDS) to hedge against defaults or adjusting allocations between investment-grade and high-yield bonds.

Volatility Control Overlays

Volatility control overlays involve dynamically adjusting the portfolio’s exposure based on market volatility levels.

Purpose and Benefits

• Risk Control – Maintain a target level of portfolio volatility.
• Stability – Reduce the impact of market fluctuations on the portfolio.
• Example – Using a mix of equity and fixed-income derivatives to maintain consistent volatility levels.

Thematic Overlays

Thematic overlays focus on specific investment or trading themes, such as technological innovation, demographic shifts, or climate change.

Purpose and Benefits

• Targeted Growth Exposure – Gain exposure to long-term investment themes. Invest in sectors or industries expected to benefit from specific trends.
• Example – ETFs focused on renewable energy or healthcare innovation.

Other Types of Overlays in Trading

Factor Overlays

These focus on specific investment factors such as value, momentum, quality, or size.

Factor overlays try to tilt the portfolio toward particular characteristics that have historically been associated with outperformance.

Geopolitical Risk Overlays

These strategies try to protect portfolios from risks associated with political events, international conflicts, or policy changes that could impact global markets.

Multi-Asset Overlays

While the document mentions several asset-specific overlays, a multi-asset overlay strategy could be used to dynamically adjust exposures across different asset classes based on the market environment or economic outlook.

Dynamic Asset Allocation Overlays

These involve actively adjusting the portfolio’s asset allocation based on short-term market views or quantitative signals.

Options-Based Overlays

While volatility overlays are mentioned, a more specific discussion of options-based strategies (like collar strategies, covered call writing, or put-spread collars) could be included.

Leverage Overlays

These involve the strategic use of leverage to improve returns or manage risk in a portfolio.

Tax Overlays

Especially relevant for taxable accounts, these strategies try to optimize after-tax returns through techniques like tax-loss harvesting or managing capital gains realizations.

Macro Overlays

These strategies adjust portfolio positioning based on macroeconomic factors such as GDP growth expectations, inflation expectations, changing risk premiums, or central bank policies.

Conclusion

Overlays are techniques in portfolio management that enable traders/investors to manage risks and capture opportunities without taking away from the core assets in the portfolio.

By incorporating various types of overlays, traders can fine-tune their portfolios to better align with their risk tolerance, return objectives, and beliefs.

These overlays provide better flexibility and precision in portfolio management, enabling traders to respond to changing markets and specific risk factors without disrupting their core investment/trading strategy.