Reducing Volatility

There are steps you can take to reduce the overall volatility of your investments. Traditional methods recommended by virtually every professional investment advisor include allocation of assets and diversification within the allocated classes. These are commonsense methods, and most investors can benefit from them.

ASSET ALLOCATION

Divide your assets: Invest some money in each of several categories (stocks, bonds, hard assets, cash equivalents, and so on). This strategy reduces the overall volatility of your portfolio, because some of those assets increase in value at the same time that others decrease. This partial offset reduces the net change or the volatility of your holdings.

Diversification

After allocating your assets, spread your investment dollars over a range of different assets in the same class. Simply put, this means:

• Don't put all your stock market dollars into the stock of only one company. Owning several stocks in each of several different industries is a simple way to diversify.
• If you decide to own bonds, don't put all your bond investments into one type of bond. Long-term governments may appeal to you, but also buy some with shorter maturities, along with some corporate bonds.

Asset allocation and diversification help reduce your exposure to the uncertainties of the markets. The goal of adopting these strategies is to minimize the effects of owning one specific asset that performs very badly (a public company going bankrupt, for example). These methods serve a purpose, but do nothing to help you earn additional income.

ANOTHER VOLATILITY-REDUCING OPTION

There is another strategy you can adopt to accomplish the dual goals of reduced volatility and increased profitability. This strategy is intended for use with stock market investments and has the added advantages of:

• Reducing losses during severe market declines
• Eliminating or greatly reducing losses during modest downturns
• Producing profits when the market is neutral and trading in a range
• Providing good profits during rising markets
• Being very profitable during strong bull markets. But in this particular type of market environment, you may make less money than you would without the strategy.

If you are willing to accept less than the maximum possible gains during strong bull markets, you can increase the performance and reduce the volatility of your stock market investments under all other market conditions. The value of your portfolio decreases at a slower rate during down markets and increases at a slower rate during strong bull markets. This results in a lower level of portfolio volatility. Overall, you make more money (or lose less) most of the time.

If owning a portfolio that is less volatile and more profitable most of the time than your current one appeals to you, then you owe it to yourself to consider using call options.

This strategy involves the use of stock options, specifically call options. It is beyond the scope of this article to give a detailed descriptions of options and how they work, but briefly:

• Contrary to current misconceptions, options are not dangerous. They are versatile investment tools that can be used to reduce risk.
• A call option gives its owner the right to buy a specific asset (100 shares of stock) at a specific price (strike price) for a specified period of time (until expiration — the third Friday of the specified month).
• When you sell a call option, you receive cash (the premium).
• If you own 100 shares of stock and sell one call option, you are covered. If the option owner exercises his rights, and you are assigned an exercise notice, you can deliver it to fulfill your contractual obligations. If you do not own the stock (dangerous), then you have an uncovered or naked position.

APPLYING IT

Let's look at an example of how this strategy works. Assume you buy 100 shares of XYZ Corp. (XYZ). The stock price is $29 per share.

If you adopt the traditional investment methodology, you simply own the shares. The value of your portfolio increases or decreases by $100 for every one-point change in the price of the stock.

If you sell an XYZ Jan 30 call:

• The buyer purchases the right to buy your 100 shares of XYZ @ $30 per share.
• That right expires on the third Friday of January 2004 (six months from now).
• You collect $4 per share (premium), or $400. You keep the $400, no matter what else happens.

When expiration day arrives in six months, there are two possible results:

(1) XYZ is above $30 per share.
The owner of the call option exercises his rights and buys your stock, paying $3,000 for 100 shares. The premium of $400 is also yours, making your total selling price $3,400. Since you paid $2,900, your profit is $500, or 17%.

(2) XYZ is below $30 per share.
The owner of the option does not buy your stock. The option expires worthless. You still own the stock. Your original cost was $2,900, but you can reduce that amount by the $400 you received from the call sale. Your cost is now $2,500, or only $25 per share.

DISSECTING THE RESULTS

If you sell your stock, the profit of 17% in six months is an outstanding return on your investment. To make the same amount without selling the call option, XYZ must trade above $34 per share.

If you don't sell your stock, you also have a good result. In order to show a profit from this investment, XYZ must be higher than your adjusted purchase price of $25 per share. To earn a profit in the traditional buy and hold method, the stock price must be higher than your original purchase price of $29. Thus, this strategy makes it much more likely that your position will earn a profit.

Let's consider portfolio volatility by comparing the value of your portfolio over a range of possible stock prices for XYZ when the option expires (Figure 1).

Figure 1: The covered call strategy versus the buy and hold approach.

With a buy and hold strategy (magenta line), the portfolio value is represented by a straight line and increases as the price of the stock increases.

With a covered call (blue line), there are two major differences:

• The maximum value for the portfolio is $3,400. If the stock goes higher than 30, you are obligated to sell at 30. Thus, the portfolio value is limited to $3,400 ($3,000 from the stock sale plus $400 from the option sale).
• If the stock declines in price, your portfolio is always worth more than it would be if you hadn't sold the call.

Adopting the covered call­writing strategy has reduced your portfolio's volatility: The account value rises or falls at a reduced rate.

SUMMARY

By using the covered call­writing strategy, you accomplish three major goals for your investment portfolio:

• Your portfolio's volatility is reduced — the value of your account fluctuates less.
• Your losses are reduced or eliminated — you lose money less often, and any loss is reduced.
• You earn profits more frequently.

You can get information about covered call writing from your broker or financial planner. However, keep in mind that many professional advisors do not understand the benefits of using options.

Mark Wolfinger has been in the options business since 1977, when he started as a market maker on the floor of the Chicago Board Options Exchange (CBOE). He now teaches individual investors how to use options conservatively. He recently wrote a book, The Short Book On Options: A Conservative Strategy For The Buy And Hold Investor. His website is www.mdwoptions.com. His e-mail address is mark@mdwoptions.com.

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