CNBC: 3 Ways To Use Market Volatility To Generate Income

CNBC: 3 Ways To Use Market Volatility To Generate Income

CNBC: 3 Ways To Use Market Volatility To Generate Income

CNBC: 3 Ways To Use Market Volatility To Generate IncomeJuly 9, 2018

By Andrew Osterland

When life gives you lemons, make lemonade.

That’s the logic behind writing options in a volatile market. The reward for giving someone else the option to buy or sell something has gone way up this year. Last year was among the least volatile in the history of the stock market, based on the Chicago Board Options Exchange Volatility Index, or VIX — a measure of volatility reflecting the prices of one month put and call options. Its average of just over 11 for 2017 was the lowest since the index was introduced in 1986.

This year, however, fear is back — and so are healthy prices for writing options.

“With premiums much higher this year, it’s a good time to write options,” said Sterling Neblett, a certified financial planner and founding partner of advisory firm Centurion Wealth. “It can be a good strategy in volatile, choppy markets.”

Option-writing strategies range from conservative (covered calls and collars) to extremely risky (naked puts). With the virtually unlimited variations of strike prices and expiration dates available, investors can customize their risk/reward parameters with remarkable precision. For someone worried about the risk of a concentrated stock position, options can reduce their exposure in a tax-efficient way.

“I can dial down beta [market risk] for a client by 50 percent using options without triggering a big tax bill,” said Dave Donnelly, managing director of SpiderRock Advisors. Donnelly’s firm implements option trading strategies for institutional investors to either hedge risk exposures or generate income from a portfolio. He also offers the service to financial advisors who don’t feel capable of managing option positions for their clients.

Most financial advisors suggest that unless you fully understand the risks of buying or selling options and are prepared to manage positions, you should leave it to an expert. It’s not for everyone.

Ken Nuttall, director of financial planning with Black Diamond Wealth Management, said he uses option-writing strategies — mostly covered call writing — with 15 percent to 20 percent of his clients.

“Our usual strategy is to use options as a way to enhance income from a portfolio,” he said.

Options are powerful tools that carry embedded leverage and far more risk than the underlying securities in the contracts. Premiums are richer now because the risks involved are higher. Buy a call option and it can become near worthless overnight after a bad earnings release. Write one and your potential losses are unlimited if the market surges upward. It’s essential that investors understand what their objective is and how much risk they’re taking with the contracts.

Here are three common option strategies that can generate income and/or limit losses from an investment portfolio.

1. Covered calls and collars

The most common, conservative way to take advantage of rich option premiums is to write call options on securities you already own. If you’re invested in stock funds, you can write on stock indexes — though the premiums are generally less than on individual stocks.

At the end of June, an option expiring on Aug. 3 to buy 100 shares of Apple at the strike price of $195 costs $2.25. That amounts to a 1.2 percent return on a monthly basis, roughly 15 percent annually, assuming you can repeat the process for 12 months.

Neblett at Centurion Wealth targets high-dividend paying stocks with a 3 percent to 4 percent yield annually and looks to add 6 percent to 7 percent by writing calls on the shares.

“We want a 1.5 percent [monthly] return for writing slightly out of the money options,” said Neblett, who prefers individual stock options and keeps durations short to limit risk.

The risk in the strategy is that the stock rises significantly and your shares are called away at the strike price. In other words, you limit your potential upside from owning the stock in return for the premium income you receive.

Writing calls does not eliminate the risk of holding the investment. The option premium provides a cushion against losses, but if the stock or index falls dramatically, so will the value of your holdings.

If investors want downside protection, they can buy puts on the position simultaneously. A collar — often called a costless collar — strategy uses the premiums from writing call options to purchase out of the money puts that limit the downside risk on an investment.

Two things to keep in mind:

  1. The longer the term on a call option, the more premium you’ll receive, but the greater the risk that your investment is called away.
  2. Single stock options pay better premiums than those on an index such as the S&P 500. They are also riskier and more volatile.

2. Straddles and strangles

Option straddles and strangles are not writing strategies that generate premium income, but rather pure plays on volatility. If an investor believes that a stock or index is going to have a big move either up or down, a straddle can help them benefit from it while limiting the potential risk.

“It’s like gambling. You’re speculating on the short-term direction of an asset.”-Sterling Neblett, founding partner, Centurion Wealth

The strategy involves buying a put and call option with the same strike price and maturity on a single security or index.

“We usually use a straddle for a specific position a client may have, and the objective is to profit from a big move in the shares either way,” Neblett said.

Investors hope that one of the options expires worthless and the other results in a windfall. The worst-case scenario is that the underlying stock doesn’t move at all and both options expire worthless. You lose your entire investment in that scenario. The break-even point is when the value of one of the options equals the cost of buying the two contracts.

If you believe there is a better chance of the underlying stock moving one way or the other, a strangle is a potential variation on the strategy. Like a straddle, the investor buys a put and call option on the same stock with the same duration but at different strike prices. If you believe the stock price will go up, buy the put at a lower strike price than the call. It costs less, increasing your potential return on a positive move, but still provides some downside protection.

3. Writing puts

Never write naked. Financial advisors agree that writing call options when you don’t own the underlying securities, or put options when you don’t have the cash to fulfill the contract, is a recipe for disaster. “Writing put and call options naked is where people get into trouble,” said Nuttall at Black Diamond Wealth Management.

“It’s like gambling,” added Centurion Wealth’s Neblett. “You’re speculating on the short-term direction of an asset.”

That doesn’t mean you have to avoid writing put option contracts. But you do need to have the cash to buy the shares if the market falls and the option is executed by the buyer.

The advantage of writing puts is that they generally carry higher premiums than call options do.

“For a client holding taxable or municipal bonds, we can sell out of the money put options on the S&P 500 index and increase their income from 200 to 500 basis points,” said Donnelly at SpiderRock Advisors. “The equity risk involved depends on how far out of the money you go.”

For example, you may like Apple stock but are worried that it’s overvalued at $185. If you write a put option with a strike price of $175, you get the premium income and the “opportunity” to buy the stock at a lower price. “You get paid to buy the stock at your desired price,” said Neblett at Centurion Wealth.

The caveat is that if Apple tanks, your potential loss on the contract is unlimited. So only write put options on stocks you feel comfortable owning, and write them far enough out of the money (i.e., below the market price) that you don’t get creamed if the market falls sharply.

In other words, as with all option-writing strategies, proceed with caution.

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