After the dramatic drop in the stock market over the past year many investors are looking for ways to invest that are less risky than being 100% long the market. The market has proven to be “too volatile” for many investors recently. If only we could find ways to be invested and get much of the upside in the market but have some kind of “hedge” against declines in the value of our investments and portfolios. ETFs to Reduce Downside Volatility Investors have looked to indexed annuities, hedge funds, market neutral funds, and broker sponsored “structured products” to try to get this ideal position of benefitting from the upside in the market but somehow limiting their downside risk.
Unfortunately with investing “there is no such thing as a free lunch”. You have to sacrifice something in order to get that downside protection. What are you willing to give up to reduce the risk of your portfolio? Are you willing to give up 1) the upside of a rising market in general? 2) liquidity? 3) low expenses? 4) simple investments that you can understand and track? or 5) upside above a certain amount (like 5%-10%) in the case of a sharp market rally? If you chose #5 then the buy/write or “covered call” strategy may be one for you to consider.
What is the buy/write investment strategy?
This is probably the most commonly used, simple, and most conservative investment strategies that involve options. Most people think of options as being risky and adding to the risk of your portfolio. This strategy uses options to actually reduce the risk in your portfolio. It is a “defensive” option strategy. It involves buying/holding a stock and “selling” a call option on the position your already own. You can do this with individual stocks or exchange traded funds (ETF’s).
By selling an option on the stock/ETF you already own you collect the option premium and you are taking in money. If the price of the stock/ETF goes down, or stays flat, or only goes up a little bit during the time of the option (often 30-60 days) you get to keep the option premium and you are better off than if you had not used the option strategy. If you keep doing this every 30-60 days over the course of a year you will keep collecting options premiums and it can add significantly to your annual returns.
When should I use the buy/write strategy?
The downside of this strategy is if the market (or your stock/ETF) takes off and zooms quickly and significantly upward. In that case you will still make money but your gains will be limited or capped at a medium amount in the short term. If you are very bullish and 100% confident on the market or on your investment positions you would not want to use the buy/write strategy because it will limit your gains on any sudden significant increase in prices. If you are not 100% confident in the market and think we may have a flat, down, or gradually increasing market (at best) then you could be better off using the buy/write strategy than being 100% invested in the market.
The buy/write strategy will usually produce better performance than a fully invested long portfolio in declining markets, flat markets, or gradually increasing markets. This strategy will have lower risk/volatility as well. Increased market volatility (like we have seen over the past year) actually increases the attractiveness of the buy/write strategy because higher volatility leads to higher premiums/prices for the calls we are selling.
Who should use this buy/write strategy?
Even though this is a relatively simple and safe strategy involving options it should still only be used by experienced and/or active investors. Other investors may be able to get comfortable with it after doing some research and homework. It will require some careful monitoring of your increased number of positions and some active trading on a regular basis to execute this strategy.
Is there an easier way to use this buy/write strategy?
Yes. There is an ETF called the Powershares SP500 Buy/Write Portfolio (symbol PBP) that invests in the SP500 index and uses the buy/write strategy. The fund writes calls on the SP500 index each month 1-month forward and takes in the option premium into the fund each month. Anyone can easily use the buy/write strategy with this PBP exchange traded fund. This fund does all the buying and call writing/selling for you.
Performance of this Buy/Write Strategy and the PBP Fund?
How has this Buy/Write fund (PBP) performed relative to the overall market as defined by the SP500 index? The Buy/Write fund clearly has outperformed in down markets. In 2008 it declined about 20% less than the overall stock market (it went down 80% as much). How about in recent flat markets? This fund also tends to outperform in flat markets. What about in booming markets? This Buy/Write fund provides you with gains, but lags the market when the market is moving quickly and significantly upwards. That is what you are giving up with this fund.
How risky is the Buy/Write Fund relative to the overall stock market? The risk of the PBP as measured by standard deviation (volatility) of returns over the past 17 months has been 23% less than the US stock market (SP500). The fund declined about 80% as much (20% less) than the market in 2008. The fund is about 20% less risky/volatile than the overall US equity market. This buy/write fund has reduced volatility relative to the overall equity market.