Investors Toolkit- Strategy

Volatility- Friend or Foe?

All investors must ultimately decide if volatility – which is the essence of the options market and influential force in the stock market – is a friend or an enemy. Ignoring volatility is arguably no longer viable as the two most recent financial crises have demonstrated that volatility is something that can be harnessed by nimble investors or something that can pummel investors.

Investor interest in volatility is often manifested in portfolio hedging to reduce the risk of owning stocks, and single-stock strategies that position investors to buy below the market and sell above the market while increasing yield and reducing risk.

Zero-Cost Collars
Hedging portfolios is often expensive, and it harms portfolio performance if the expected decline never happens. This is why the “zero-cost collar” is often popular because it eliminates hedging expenses in return for limiting upside returns. An investor, for example, who wanted to hedge a portfolio that tracks the Standard & Poor’s 500 Index could create a zero-cost collar with S&P 500 options. To craft the “collar,” an investor could buy a put which would increase in value if the stock market fell by about 5% to 10%. To offset the cost of the put, the investor could sell a call option to cover the expense.

The hedge could protect the portfolio against declines, but limit gains. The key risk: the market surges above the short call, requiring investors to cover the call, adjust the strategy, or otherwise not participate in the rally.

Managing Stocks
Everyone likes selling high and buying low. In the options market, investors create those favorable conditions with covered-call and cash-secured put strategies, which essentially pays them for agreeing to sell or buy stocks.

The Covered-Call Strategy
By selling upside calls against stocks in their portfolio, investors can generate income and enhance investment returns. The standard approach is selling calls with strike prices that are 5% to 10% above the stock price and that expire in under three months.
Pick any major stock. An investor could sell a call with a strike price that is about 10% above the stock price. If the stock remains below the strike price, investors keep the premium. If the stock is above the strike price at expiration, investors are obligated to sell the stock or buy back the call.

Cash-secured Puts
The cash-secured put sale is often used to position to buy stocks at below-market prices. To do so, investors deposit in their brokerage account the money needed to buy a stock, and then they sell a put option. Most people sell puts 5% to 10% below the stock price and that expires in under three months. If the stock is above the put strike price at expiration, investors keep the put premium. Should the stock price be below the strike price at expiration, investors buy the stock or buy back the put. This strategy is best used only on stocks an investor wants to own. The strategy is currently quite popular among investors who were scared to the sidelines by the COVID-19 pandemic and want to re-enter the market without paying top dollar. Pick any major stock. An investor could sell a put that is 10% below the stock’s price. If the stock was above the strike price at
expiration, investors could keep the premium. If the stock was below the strike price at expiration, investors would have been obligated to buy the stock or buy back the put.

Conclusion

These conservative strategies proactively embrace the principles of good investing that include generating incremental income, increasing returns, and buying below and selling above the market.

To be sure, every financial crisis makes more investors realize that volatility can be an important ally. That we have experienced two, 100-year crises in a decade are unthinkable. Yet, it has created a permanent demand for strategies that help investors achieve investment goals that once were accepted as the natural conclusion of diversified portfolios and long-term investment horizons.

This case study is also available in printable PDF format.

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