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Options can be complex, but they have their place in an investor’s overall toolkit.  When used judiciously, options can help increase the income generated by a portfolio and provide downside protection to wary investors.  Although the news in recent years has highlighted the risks of certain investment strategies, such as options, the headlines shouldn’t dissuade investors from learning more.

A good first step is mutual funds.  This may sound odd in an article about options, but analyzing a select group of mutual funds that make use of options techniques can help investors both understand the technique and the logic behind it, and see the real world results that were generated using the technique (instead of hypothetical performance examples).  In the end, it may prove easier to buy the mutual fund.  Or, for those seeking more control over their portfolios, simply learning by example, or even borrowing some of the fund’s techniques, may work best.

Covered Calls

Generating income with covered calls is, perhaps, one of the most prevalent uses of options.  The basic strategy is for an investor to buy a stock and then give someone else the right, but not the obligation, to buy it at a higher price.  That right, called a call option, comes at a price, or premium, that the owner of the shares gets to pocket no matter what happens.  This process is called selling a covered call because the investor selling the call owns the stock.

If the stock doesn’t reach the price stipulated by the call, it is highly unlikely that the person who bought the option would exercise his or her right to buy the stock.  If the call option is not exercised, the stock’s owner gets to keep the stock and the money paid for the call.  If, however, the stock price appreciates above the price stipulated by the call, it is likely that the person who purchased the call will exercise his or her right to purchase the stock.  In this scenario, the original investor gets the premium paid for the call and any difference between the price originally paid for the stock and the price at which it was sold. 

If this all sounds confusing, it can be.  But once the process has been worked through a couple of times it should become old hat.  How has this process gone for other investors?  Take a look at Van Kampen Equity Premium Income Fund (VEPAX).

The fund’s objective is current income with a secondary investment objective of long-term capital appreciation.  It is an “income-oriented stock investment combining an actively managed portfolio of large company stocks with the writing of covered call options.”  Unlike some other products that use this technique, particularly exchange traded funds (ETF), management of Van Kampen Equity Premium Income Fund uses an active, quantitatively driven approach when selecting investments.  The goal is to create a portfolio that is similar to the S&P 500 Index, but with enhanced total return potential. 

In flat, slowly rising, or down markets, management expects the fund’s covered call strategies to help generate additional income. (The fund is designed to provide monthly income.)  In quickly rising markets, the fund seeks to deliver market-like returns with less risk.  The covered call strategy will likely limit the upside potential of the fund, however the income earned from the premiums may help minimize some of the downside if a stock's price begins to decline and provides an added source of return.

Although the fund lagged its Growth and Income peer group in the first quarter of 2010, its trailing three-year performance through the end of March is solidly in the top third of the group’s return.  The load fund isn’t materially less volatile than the peer group, however, that isn’t its goal.  Still, it is less volatile than Vanguard 500 Index Fund (VFINX).  The dividend yield isn’t spectacular, but, as a reference, it is more than one percentage point higher than Vanguard 500 Index Fund’s yield.  For those interested in covered calls, this is an interesting fund to review before taking the leap either on your own or through a fund or ETF.

Downside Protection

One of the longest available funds using options to protect its portfolio from market volatility is Gateway Fund (GATEX).  This load fund seeks to “capture a substantial portion of the long-term total return potential of equities, while limiting portfolio volatility to a level similar to that of long-term bonds.”  That’s a tall order.  To achieve this goal, management uses a two-prong approach. 

First, it seeks to generate cash flow by selling index call options against the portfolio, much like the Van Kampen Fund noted above.  Second, it purchases index put options to help reduce downside exposure. 

A put option is like the reverse of a call option, in that the person buying the put is purchasing the right, but not the obligation, to force the put seller to buy a security at a set price.  Thus, if the price of the stock or index against which the put option was sold falls below the price at which the option was sold, the person selling the put would be forced to buy the underling security at the higher price stipulated by the put.  If the price of the underling security does not fall below the put price, the option expires and the put seller gets to keep the premium paid.  Then, the put buyer is simply out the money. 

Most can instantly see the limitations here; the covered calls limit the upside potential, as with the Van Kampen Fund, with the costs of the puts adding a further drag.  That said, the downside protection should defend against catastrophic loss.  As you might expect, the fund isn’t a performance standout, but it is roughly half as volatile, as measured by standard deviation, as the average Growth and Income fund under Value Line’s review.  So, for a risk-conscious investor, the fund might make an interesting selection.  For the investors seeking to get their hands dirty and dig into puts, the fund’s tactics and performance might help illustrate the process.

There are a select group of funds that use each of the above techniques, including both closed-end funds and exchange-traded funds.  The two highlighted above are simply examples that use two basic option techniques.  Investors interested in options should take the time not only to review these and similar funds, but also the education articles available from Value Line.  When used appropriately, options can be vary beneficial and truly worth the time spent educating oneself about the opportunities and risks.