With day-to-day volatility, a common occurrence in the stock market is finding ways to smooth out those gyrations and ultimately enhance returns in a downward market. While the global equity markets have experienced tremendous upside from their March lows, fear and general malaise are still ringing true. It's hard to feel 100% confident when some big named analysts and economists, such as Peter Schiff, are still calling for global depression.
Given all the economy's positives, such as the increase in consumer confidence or the possible peak in unemployment, such doom and gloom seems improbable. However, it is entirely possible that the equity markets could take a slight breather in October and drift sideways. For retail investors there are ways to hedge the downside and enhance the sideways return of market if we follow a technique used by institutional investors.
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Making the Write Call
Options strategies have often been the realm of day traders, high net-worth individuals and institutions, and are often ignored by the retail investor space. However, several exchange-traded funds (ETFs) have entered the space, applying a simple buy-write strategy in order to cushion the blows in falling or sideward markets. At its very basic, a buy-write or covered call is an investment approach where the investor buys a stock or a basket of stocks tied to an index and writes call options that cover the stock position. The advantages of this are that the option premium cushions downside moves in an equity portfolio.
One negative side effect of this hedge is limited upside as the index or stock moves above the options strike price. Buy-writes are designed to outperform stocks in neutral and bear markets and underperform stocks in bull markets.
Smooth Out Returns
By taking a sophisticated tool and placing it in a neat exchange-traded package, more retail investors have the opportunity to use it in their portfolios. These ETFs eliminate the lengthy research and "manual" call writing. While these options funds have yet to command real investment dollars, as the daily and weekly gyrations continue they should begin to attract some real interest as a hedge. Currently there are three buy-write exchange traded products. Two that follow the popular S&P 500 (NYSE:SPY) and one that follows the Nasdaq 100 (Nasdaq: QQQQ).
The PowerShares S&P 500 Buy-Write Fund (NYSE: PBP) provides a 0.81 correlation to the S&P 500 while outperforming it by tracking the CBOE S&P 500 Buy-Write Index. Since the fund's inception in December 2007 it has returned -15.61% versus the broad indexes -24.95%. The fund yields 1.60% and charges 0.75% in expenses.
For investors wanting a more cost-effective buy-write hedge, the exchange-traded note (ETN) structured iPath CBOE S&P 500 Buy-Write Index ETN (NYSE: BWV) offers similar exposure to the CBOE index. The ETN is a senior, unsecured, debt security issued by Barclays (NYSE: BCS) providing the return of that index. The note is set to mature in 2037. (Learn more about ETNs in Exchange Traded Notes - An Alternative To ETFs.)
For tech-heavy investors, the PowerShares NASDAQ-100 Buy-Write (NASDAQ: PQBW) provides exposure to the popular Nasdaq 100, including holdings and call options in Microsoft Corporation (NASDAQ: MSFT) and Garmin (NASDAQ: GRMN). The fund has outperformed its S&P sister, up nearly 33% year to date, while PBP is up about 11%. The fund also charges 0.75% in expenses.
In the current market environment, any form of insurance is welcome. Options, specifically covered calls, can offer a downside or sideways cushion against losses and volatility. The boom in ETFs has taken a tool that is normally left for institutional investors and given it to the masses. The three preceding funds offer an easy way to add buy-write insurance to your portfolio.
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