|If you are like most individual investors who own stocks or mutual funds, the value of your portfolio has fluctuated dramatically in recent years. The markets soared during the latter 1990s, only to plummet, dashing both the value of your holdings and your financial dreams. Were you able to tolerate the rapid change in the value of your assets? Would you have preferred an investment strategy that removed a bit of the excitement during the bullish years and some of the trepidation in recent times? |
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.
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.
After allocating your assets, spread your investment dollars over a range of different assets in the same class. Simply put, this means:
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:
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:
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:
When expiration day arrives in six months, there are two possible results:
(1) XYZ is above $30 per share.
(2) XYZ is below $30 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:
Adopting the covered callwriting strategy has reduced your portfolio's volatility: The account value rises or falls at a reduced rate.
By using the covered callwriting strategy, you accomplish three major goals for your investment portfolio:
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 email@example.com.
SUGGESTED READINGWolfinger, Mark . The Short Book On Options: A Conservative Strategy For The Buy And Hold Investor, 1stBooks Library.
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