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Surviving Volatility With Covered Calls

There is no perfect substitute for cash, but the intrepid have options.

Michael Rawson, 05/27/2010

Many investors have not had a good night of sleep since 2007, and it will likely be more difficult for the next few months with the fear alarm blaring. Volatility is back with a vengeance. Other than during the financial crisis of 2008, volatility has scraped today's levels only for brief moments. The Russian debt default that led to the collapse of Long Term Capital Management in 1998, the attacks of Sept. 11, 2001, and the launch of the second Gulf War are the only other periods over the past 20 years in which volatility was as high as it is today, and the index never surpassed 50 during any of those historic events.

Many people believed the 2009 rally went too far too fast, and some people did not believe that the economy was actually just fine all along. Instead of fixing the underlying structural problems, government intervention across the globe simply spread the pain out over a longer timeframe and transferred the agony into different forms. With big brother on our side, the bankruptcy of many domestic financial firms is no longer a pressing fear; anemic growth and the fear of wealth redistribution through global inflationary policies are more tangible. While they may be necessary today to deal with the deflationary slack in developed economies, future problems will be more difficult to resolve with each bout of printing-press solutions.

Investors with regret about not returning to the market earlier and with cash to deploy should welcome the recent panic in the market with open arms. They have been given with the opportunity to become fully invested over the next few months at the lower price point that the recent uncertainty provides. Even if they decide not to become fully invested in the market, they can at least rebalance a portion of their cash stake into the riskier equity and fixed income markets to bring them back to their target allocation levels.

Those looking to maintain their exposure to equity markets can also benefit from today's elevated volatility by deploying one of the less-risky income-enhancing strategies available through the options market. Covered call writing is a low risk way to earn a profit from an existing holding in your portfolio, particularly when volatility is high or you have the view that the underlying security is fairly valued or has limited upside potential.

Here is an example, let's say that after the market started to rebound last year, you purchased 100 shares of SPDR S&P 500 SPY at the end of July.  You are now sitting on a gain of about 8%.  If, like our Morningstar analysts, you feel that the market is approximately fairly valued at these levels you may not see much potential for the market to go up or down over the next couple of months. Selling the ETF now would incur a short-term capital gain. An alternative approach would be to write a call option, perhaps at a strike price 5% above the market price. As of this writing, the SPDR is trading at about $106 and July call options with a strike at $111 currently trade for about $2.40 for one contract covering 100 shares of the ETF.PAGEBREAK

Now, at expiration two months from now, if the SPDR goes down or goes up by less than 5% (the most likely scenario), the option expires worthless, you keep the premium and your underlying position in the SPDR.  But if the market goes up by more than 5%, you keep the premium, your position in the SPDR will get called away and for it you will get paid the strike price of $111.  So if the market does go up, your upside is capped at 7% (the return from $106 to the strike plus of $111 plus the $2.40 premium).  If it goes down, your downside is reduced slightly by the amount of the premium.

While it may seem like a drawback that your ETF gets called away when the market goes up, remember that your view was that the market was fairly valued and unlikely to move strongly in either direction. Although having your option called away will trigger the short-term capital gain, you have earned an additional 7%.

Another instance where covered call writing may be appropriate is when market volatility is high and you expect it to fall. Volatility is the underlying driver of options prices. The greater the volatility, the greater the probability that the underlying may have a big move and end up in the money at expiration. The covered call writer can take advantage of spikes in volatility by writing call options and earning the premium at a time when premiums are high.

When is this not a good strategy? While writing covered calls does help to slightly reduce your exposure on the downside, if you are concerned the market is going to go down a better approach may be to sell all or a portion of your investment.  Additionally, your participation in a market rally will be capped, so the strategy is really only appropriate when you have the view that the market is fairly valued and unlikely to move strongly in either direction.

We recommend trading options only on the most liquid ETFs.  For example, options exist on both SPDR S&P 500 and iShares S&P 500 Index IVV, however the options on the SPDR are much more liquid and have narrower spreads.

There's good news for those of you who found the covered call strategy discussed above appealing, but find investing in options to be a little too intimidating. PowerShares offers two buy-write options strategies: PowerShares S&P 500 BuyWrite Portfolio PBP and PowerShares NASDAQ-100 BuyWrite Portfolio PQBW. These are both the equivalent of running covered call strategies on the respective underlying indexes. Keep in mind though, that these strategies make the most sense during flat or only moderately rising markets. The portfolios are relatively new and thus we have limited performance data to analyze. In a market that rose as rapidly as it did last year from the March lows, a covered call strategy would typically underperform. The reason would be that as the market shoots higher, there's a stronger likelihood that your position gets called away and you end up forfeiting some of your upside. Still looking back at 2009, we see that PBP delivered a return of 25% versus about 26% for SPY. (These figures account for the difference in expense ratios between the two funds.) The kicker though, is that PBP did it with a standard deviation (a common measure of risk) of 14% compared with 20% for SPY.

The performance of PQBW was less inspiring, but that's what we would've expected considering tech's strong rally through the recovery. The fund delivered a 44% return with 13% standard deviation last year. PowerShares QQQ QQQQ, however, returned more than 54% in 2009 with standard deviation of about 21%. There are likely investors out there who would gladly sacrifice a few points of return for damped volatility. These funds could be a solid choice for such investors.

Michael Rawson is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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