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These Tools can be Profitable, but Risky

How to use options without the risk of blowing up.

Josh Charney, 07/05/2012

A financial option represents a right that can be bought and sold. Purchasing a put option, for example, grants the buyer the right to put a stock back to the option's seller at a predetermined price. The implications of trading options are profound--a manager can limit a portfolio's risk or even generate a return stream through a few simple trades. But as Warren Buffett once referred to derivatives as "financial weapons of mass destruction," investors should understand the strategies and not invest in option-based funds unless they are comfortable with its risks.

Pure Plays or Hedgers
Breaking down option funds into two buckets simplifies the options universe. The first group of funds uses options as their primary strategy. The most common type of income-generating strategy is referred to as covered call. These offerings use a relatively straightforward strategy: buying a basket of stocks and selling call options. There are, however, risks involved with covered-call strategies. First, selling call options caps one's gains, so major gains of the stock are transferred to the option's holder. Second, the downside risks are borne by the holder of the stock; thus, by selling covered calls, one's upside is capped while the stock could still fall substantially.

The second group of funds uses options to augment their daily process. Danger may be prevalent, and though investors may not feel compelled to ask questions about these strategies in good times, nobody wants to be on the receiving end of huge losses. For this reason, alternative funds use the new Global Fund Report format, which includes an expanded process section to explain ancillary strategies.

A buy-write strategy is another name for selling covered calls, in which an investor buys an underlying stock, or basket of stocks, and sells short call options. There are primarily two exchange-traded products, or ETPs, that follow this strategy: PowerShares S&P 500 BuyWrite PBP and iPath CBOE S&P 500 BuyWrite Index ETN BWV. Both ETPs track the CBOE S&P 500 BuyWrite Index. The index works by buying S&P 500 stocks and selling the shortest-duration and closest to-the-money call options. On the third Friday of every month, when either the options are exercised or expire worthless, the index will sell the next month's closest to-the-money call options. Because the index utilizes European-style options, there is no risk of being called.

There's another hidden benefit to investing in a buy-write strategy. Owning the stocks outright means investors collect dividends to supplement the strategy. Looking back at the returns of the CBOE S&P 500 BuyWrite Index, it's held up better during times of strain. In 2008, for instance, the index only fell 28.7% compared to a decline of 37.0% for the S&P 500, because the index was able to generate extra income by selling calls. In 2009, the index was able to keep pace with the S&P 500, gaining 25.9% while the S&P 500 went up 26.6%. During times of heightened volatility, the fund can profit from the extra volatility premium.

A lesser-known strategy among retail investors is put-writing, which is comparable to selling insurance. An investor who sells puts risks losing a substantial amount of money, while gains are capped by the cost of the put option. Though this strategy is more common in the hedge fund space, Kinetics Multi-Disciplinary KMDAX is the only option available in the "40 act" space. The fund sells put options on a basket of stocks that are selected through bottom-up fundamental research. It invests its assets in B- or higher rated corporate bonds, with a duration of less than five years. Management doesn't risk more money than the value of the bonds. Puts options are not indiscriminately sold on an index; instead, management uses a bottom-up stock-picking process and sells put options on companies they would want to own.

The fund acts primarily as a deleveraged equity fund and offers returns similar to funds in the conservative allocation category. It is also less volatile than the CBOE S&P 500 Putwrite Index. The Putwrite Index has shown strength in tough times. In 2008, for instance, it fell by about 10% less than the S&P 500 but beat the S&P 500 in 2009. The index also has exhibited better risk-adjusted returns than both the covered-call and S&P 500 Indexes over the last 10 years. Though the fund has exhibited worse risk-adjusted returns than the Putwrite index, it has fared substantially better then the S&P 500, on a risk-adjusted basis, since inception. If investors understand the risks pertaining to this strategy, indeed, selling insuring can be a profitable endeavor.

Volatility in Play
Experienced investors who have an outlook on where volatility is headed have ample choices in the ETP space. IPath, for instance, offers the iPath S&P 500 VIX ST Futures ETN VXX, which tracks the S&P 500 VIX Short-Term Total Return Index. The benefits of owning the index is that it has acted like a hedge in dark times (the index went up 126.5% in 2008). But buyers beware: The index also can fall substantially (it fell a whopping 72.0% in 2010) and has contango risk (not recommended for long-term holding). Fearful investors looking to put money in this space should consider a managed product instead.

Josh Charney is an alternative investments analyst at Morningstar.

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