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The Time Might be Right for BuyWrite

Options for profiting in the "new normal."

John Gabriel, 02/08/2010

Even though things looked extremely grim early on, 2009 ended up being a wonderful year to be long in the markets. But, on the heels of a monumental rally that saw major market indexes bounce 70% off their lows, many investors are now beginning to question the sustainability of the market's recovery. With the market's margin of safety narrowing significantly, a healthy degree of caution seems warranted.

Indeed, this a difficult and stressful time for many investors. While recent economic data have shown signs of improvement and provided rays of hope for the bulls, there are still lingering concerns about how the market might react to a withdrawal of government stimulus. Moreover, regulatory risks cannot be ignored, particularly for the health-care, energy, and financial sectors.

With exogenous factors today playing such vital roles in important sectors of our economy, it is difficult to develop conviction in the stock market. Subscribers to Morningstar ETFInvestor are familiar with our preference to pick up yield from relatively conservative industries, but other strategies can help ensure higher returns by giving away some of the upside potential. Some investors might consider trading options around their equity portfolio in order to collect some premiums (and even manage risk).

Covered Calls
One of the more basic (and conservative) option strategies involves selling call options on a security that you already own in your portfolio, and many liquid ETFs have liquid option markets on their underlying products. Using a covered call strategy with an ETF can be a particularly attractive strategy when volatility appears relatively expensive. Co-editor and portfolio manager of Morningstar OptionInvestor pens a weekly article discussing volatility trends. The timely analysis offered in the reports should serve as a valuable resource for option investors.

Recently, when the VIX briefly touched 17, it looked as if the market was being lulled into a sense of complacency. (See our recent commentary here.) However, things reversed course quickly. Investors are getting nervous about the fragility of the economy and how stocks could be impacted once the massive stimulus effects wear off. Investors have a few options, aside from going to cash or joining the bond market stampede.

Rather than selling and running for cover, selling calls can be an excellent way to enhance returns in a sideways trading market. Think of the premiums you collect as extra income. Currently, investors selling calls on the SPDRs SPY with a strike price that's roughly 7% out of the money would be collecting an additional 4% (annualized) on their investment through the call premiums. Of course, if there was a spike in volatility, the annualized premium could rise significantly. Furthermore, you have no downside protection if the S&P 500 falls, and your upside potential would be limited by your strike price.

By rolling contracts month to month and keeping exposures to 30 days or less, an investor would be able to take advantage of rising volatility in the markets. This is a similar concept to the bond investor who manages the duration of his portfolio around movements of interest rates. It swings both ways. So for instance, if we were to experience a sharp rise in implied volatility and options became relatively expensive, an investor could extend his or her exposure out to a year or more to lock in nice fat call premiums.

Of course, options aren't for everyone. Also, each investor's situation is unique. Among things to consider would be the cost basis of the investment being secured by the call options, whether the investor is willing to trigger a taxable event, and so on.PAGEBREAK

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