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.
• Building a Resilient, Cash Flow-Focused Portfolio – We give an example of how overlays, in the context of a stock portfolio, can help separate the cash flow stream from market-driven price swings and macroeconomic shocks, producing a more stable return profile. This overlay strategy transforms a stock portfolio from a price-sensitive instrument into a cash flow-focused investment, delivering steadier returns in both turbulent and calm markets.

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.

Example: Overlays in Steadying a Stock Portfolio

Creating a smoother return stream in a stock portfolio can be challenging, given equity markets are inherently volatile due to their longer duration and variable cash flows.

As we’ve covered in other articles, there are four main variables that influence asset prices at the macro level:

• changes in discount rates
• changes in risk premiums
• changes in discounted growth
• changes in discounted inflation

To address this, portfolio managers increasingly use derivatives as overlays to buffer against sharp price swings and unpredictable macroeconomic shifts.

Let’s break down how a range of derivatives – interest rate, credit spreads, inflation, and growth – can act as strategic overlays, effectively stabilizing returns and reducing short-term risks in a cash flow-focused equities portfolio.

Designing a Cash Flow-Oriented Equities Portfolio

Traditional stock portfolios rely heavily on the performance of selected companies and their earnings potential.

Nonetheless, in the short run, stock prices can be highly sensitive to broader economic factors, often more so than to company-specific fundamentals.

For example, if a company is trading at 25x earnings, it earns 1% of its value per quarter.

That’s not much.

Its price is more likely to be driven by macroeconomic factors and general sentiment much more than its actual earnings.

By creating a portfolio that isolates cash flow from market-driven price fluctuations, trades/investors can achieve a more predictable return stream.

This stability becomes important in an environment where there are low yield and/or higher inflation volatility relative to growth volatility, where bonds no longer serve as reliable income generators or counterweights to stock risk.

Derivatives manage external influences like interest rates, inflation expectations, and economic growth factors, aligning the portfolio closer to a cash flow-focused performance.

Step 1: Interest Rate Derivatives – Managing Discount Rate Volatility

Interest rate changes can have a significant impact on stock valuations, as they directly influence discount rates used to assess future cash flows.

When interest rates rise (more than what’s discounted), the discounted present value of a company’s future cash flows declines, leading to lower stock valuations.

To smooth the influence of fluctuating interest rates, portfolio managers can use interest rate derivatives, such as swaps or bond futures, to hedge this risk.

If interest rate swaps, for example, a manager can lock in a fixed interest rate, reducing sensitivity to future rate changes (if they measure things accurately).

If rates rise unexpectedly, the portfolio’s downside from declining valuations could be partially offset by gains in the swaps.

Bond futures offer a similar cushion by acting as a counterweight to stocks: when interest rates climb, bond prices fall, but bond futures increase in value.

These hedges effectively insulate the portfolio from abrupt swings in discount rates.

Accordingly, it can preserve a steadier cash flow-driven return profile.

Step 2: Credit Spread Derivatives – Balancing the Risk Premium

Credit spreads, or the difference in yield between corporate bonds and risk-free government bonds, capture market perceptions of risk.

They’re inherently a risk premium – i.e., the difference between the yield for a certain level of credit risk vs. the equivalent duration government bond.

Accordingly, when credit spreads widen, it often signals increased risk premiums, which can erode stock valuations as investors demand higher returns to compensate for greater perceived risk.

To mitigate this effect, credit spread derivatives, such as credit default swaps (CDS), come into play.

By shorting credit spreads, a trader/manager can gain when spreads widen, offsetting some of the portfolio’s potential decline in value as risk premiums rise.

Again, assuming everything is measured out appropriately.

Credit derivatives thus help stabilize returns by balancing the risk premium impact, allowing the portfolio to stay closer to its cash flow fundamentals.

Step 3: Inflation Derivatives – Smoothing the Impact of Rising Costs

Inflation can be a significant source of volatility in stock portfolios, as rising inflation affects revenue, operational costs, and the value of future cash flows.

Companies often experience declining profit margins as costs increase, which can hurt stock prices.

At the same time, inflation erodes the purchasing power of future cash flows.

This is where inflation derivatives (e.g., inflation swaps) can offer an important overlay.

With inflation swaps, a portfolio manager can “swap” variable inflation rates for fixed ones, providing certainty about future inflation costs.

If inflation rises sharply, the inflation swaps gain in value, counteracting some of the inflation-induced drag on stock performance.

This stabilizing effect ensures that inflation volatility doesn’t undercut the portfolio’s returns, particularly in times when cash flow generation is already under pressure.

Since inflation swaps are open almost exclusively to institutional investors, alternatives include:

• going long TIPS, and short equivalent nominal bonds
• other inflation derivatives, which many brokers now have (but may be overly binary and not continuous)

Step 4: Growth Derivatives – Managing Growth Expectations

Market expectations for economic growth help shape stock valuations, as they influence both earnings growth potential and the overall economic environment.

When growth expectations shift suddenly – due to economic data releases, policy changes, or global events – stocks tend to experience synchronized price moves that can disrupt a portfolio’s performance.

When we talk about stabilizing an equity portfolio, security selection often comes up.

For example, buying consumer staples and utility stocks because their cash flows are more predictable.

While that can be a start, all stocks mostly go up and down together.

So, security selection only goes so far.

Growth derivatives – where they exist – can help moderate these growth-driven shocks.

One approach involves using growth-linked derivatives that hedge against shifts in economic growth indicators, such as GDP or earnings growth.

Like with inflation derivatives, many brokers now offer some form of economic growth/GDP derivatives.

For instance, a derivative linked to GDP growth could provide payouts if economic growth falters.

In turn, this could cushion the portfolio from sudden valuation adjustments tied to lowered growth expectations.

Similarly, growth-rate derivatives tied to industry indices can offer protection against sector-specific growth declines, and in turn allow the portfolio to remain aligned with its cash flow-driven objectives.

How Macro Overlays Achieve Portfolio Stability

With these overlays in place, the portfolio becomes more resilient to short-term shocks.

It isolates the cash flow component from volatile pricing elements influenced by macroeconomic factors.

Here’s how each derivative overlay contributes to a smoother return profile:

1. Neutralizing Short-Term Volatility – The interest rate and credit spread derivatives act as primary shields, dampening the immediate impacts of changing discount rates and risk premiums.
2. Enhancing Transaction Efficiency – Macro overlays allow the manager to hedge against broad economic shifts rather than executing costly, stock-by-stock adjustments. This efficiency also makes it easier to adjust the portfolio’s hedge ratios in response to macroeconomic data, minimizing unnecessary transaction costs. Shorting isn’t necessary.
3. Stabilizing Long-Term Returns – From offsetting external risks with derivatives, the portfolio achieves a higher degree of return stability, helping long-term returns reflect the underlying cash flows more accurately rather than market sentiment.

Extending Resilience Through Strategic Diversification

While derivatives reduce volatility on a macro level, further stability can be achieved through geographic and sector diversification.

Geographic diversification, for instance, reduces the impact of country-specific economic shifts, while sector diversification ensures that different industries’ varying responses to economic conditions don’t overly expose the portfolio to downturns in any single sector.

Dividend-paying and income-generating assets also add liquidity, so that the portfolio has resources to reinvest in undervalued stocks or reallocate as necessary.

And, of course, this just pertains to stocks.

Further diversification can be had by going to other asset classes, like bonds/fixed-income and commodities.

Balancing Liquidity with Long-Term Stability

Liquidity is a key aspect often overlooked in volatility management.

A portfolio with both liquid assets and high cash flow stocks can weather downturns more effectively.

Dividends from stable, cash-generating companies offer a buffer during price declines, so that the portfolio is generating steady income even in volatile markets.

Maintaining liquidity through dividend-paying stocks also better enables strategic repositioning in response to economic shifts, further aligning the portfolio with its cash flow-driven design.

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.