Using Covered Calls to Play Volatility

 | Sep 12, 2016 | 2:00 PM EDT
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Stock quotes in this article:

VXX

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TVIX

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nke

How do you fortify your portfolio in times of increased volatility? That's a great question -- and one I've been asked quite a bit over the past few days.

It almost seems as if people are asking the question sheepishly, as in, "I should know this, but ..." However, there's nothing to embarrassed about.

After all, volatility has been trending downward for so long that it's perfectly understandable for folks to have forgotten how lucrative trading volatility can be. Look at a long-term chart of the iPath S&P 500 VIX ST Futures ETN (VXX) or the VelocityShares Daily 2x VIX ST ETN (TVIX) if you don't believe me.

Now, volatility looked like an endangered species prior to Labor Day, but came roaring back last week. As a result, smart investors need to understand the meaning of volatility, along with indices like the CBOE Volatility Index (or "VIX") and the concept of options trading.

For openers, "volatility" simply measures price movement. If the Dow industrials are at 18,000 and have three days of +180, -182 and +180 moves, that represents the same magnitude of volatility that three days of -180, -178 and -176 moves would. In both cases, the Dow will have seen three straight days of +/- 1% moves.

However, "implied volatility" is priced based on just downside moves, and any tendency toward the downside will increase the cost of buying volatility options. That's why Wall Street calls the VIX a "fear gauge."

Smart propeller-heads can figure ways to arbitrage the differences between actual volatility and implied volatility. However, the VIX is far from a perfect indicator, and is guilty (as Paul Samuelson once famously remarked about the stock market as a whole) of predicting nine of the last five recessions.

How to Play Volatility
Fortunately, increased volatility makes writing covered calls -- the simplest, least-risky method of portfolio insurance around -- even more lucrative.

Now, writing covered calls is easy to do, but many investors (even financially savvy ones) seem to have an innate fear of doing so for reasons that I've never quite understood. I suppose it's because equity options derive their value from the underlying stock involved, which technically makes them "derivatives." Unfortunately, the "D-word" got widely maligned during and after the 2008-09 financial crisis.

However, the reality is that writing a call against a fully covered position is a riskless strategy. So, get over it. Conquer your fear and write calls against your largest positions.

After all, writing a covered call gives you instant income in the way that even quarterly dividends don't. And it reduces your risk on and underlying stock position, as the call premium that you'll receive will effectively lower your cost basis. This in turn lowers your so-called "value at risk" (or "VAR").

So, just do it. Go to your brokerage account, click on a position and click on the options tab. Go out one month, go to a strike price that's higher than the current value (preserving some upside for yourself) and write a number of calls that equals the number of shares you own divided by 100.

There, you just did it! And I chose the phrase "Just Do It" intentionally, because Nike (NKE) has recently been a prime candidate for "buy/write" strategies that use covered calls. It's got a great brand, a great balance sheet and great potential for growth in emerging markets, but the stock has been an absolute dog this year.

In fact, NKE seems to be battling Disney for the title of "Worst Dow Industrial Stock of 2016." Holding a name that's down 11% so far this year in a market that's up 5% can really crush your portfolio's relative performance.

I know, I know ... you love Nike and want to hold it for the long term. Fair enough. Simply write covered calls against your NKE long and bolster your near-term performance until the market falls in love with the athletic-equipment giant again.

You'll be protecting the value of your NKE position against an October Surprise from the overall market. So ... just do it.

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