By JACK HOUGH
Stocks have generated more worry than gains this year -- and for more than a decade. Yet slim yields on bonds and savings give stockholders little enticement to sell.
The result for many investors is an unlovely combination of high fear and low reward.
There is one way to steady a stock portfolio without unloading shares, however: an options strategy known as "covered calls." The idea is to collect extra income now in exchange for giving up potential gains later.
Research suggests investors who use covered calls can turn the risk-reward trade-off in their favor by using a strategy based on stock indexes rather than individual stocks.
First, some terminology. Calls are option contracts that can give buyers an inexpensive bet that a stock will rise above a specified "strike price" before a specified date. A call "writer" collects the price of the bet (the "premium"), but might have to deliver the shares if the stock tops the strike price. He's "covered" if he already owns the shares.
"Puts," by contrast, offer buyers protection against a stock decline. Put writers collect a premium by giving buyers the right to sell the stock at the strike price -- but, like insurers, writers might have to pay if disaster strikes.
Depending on the strategy, calls can be used to reduce risk (covered call-writing) or to add staggering amounts of risk ("naked" call-writing), so brokers issue options-trading permission only selectively.
Call writers should have no advantage over call buyers. "If you write a call on your IBM shares, you reduce both risk and potential return, one for one," says Bob Whaley, a Vanderbilt University professor who in 1993 developed the Chicago Board Options Exchange Market Volatility Index, or VIX, which tracks investor expectations for market volatility.
Indeed, mutual funds that used options for either speculation or hedging from July 2003 to June 2007 showed no sign of market-beating returns after adjusting for risk, according to a working paper by Gjergji Cici, an assistant professor at the College of William and Mary. He says there is limited research on the subject because the historic data are "a mess."
One type of option might offer more opportunity than others, however. Some researchers say a quirk related to index options, like those written against the Standard & Poor's 500-stock index, offers investors a way to reduce risk without giving up much in return.
At least nine research papers since 1990, from academia and Wall Street, have shown that index options are often overpriced -- an opportunity for those who sell them.
In the options world, contract prices are directly related to the volatility of the underlying securities. That is how the VIX works: An investor who knows the prices others are paying for options on the S&P 500 can calculate the volatility those investors expect.
With individual stocks, this "implied volatility" tends to match pretty closely with actual volatility over long time periods. That suggests neither buyers or sellers have a predictable price advantage.
But the VIX overestimates the broad S&P 500's future volatility more than 80% of the time, according to Josh Parker, president of options specialist Gargoyle Investment Advisor.
There is a good reason. Institutional investors have ravenous demand for index puts, since they offer cheap protection against a market crash, Mr. Parker says. All that buying pushes index put prices higher -- and call prices, too, because the two move in tandem. That suggests an investor who writes index options is getting a better price than one who buys, on average.
In 2001, Vanderbilt's Mr. Whaley developed an index to exploit the high price of index options. It is called the CBOE S&P 500 BuyWrite Index, or BXM, and it simulates owning the S&P 500 and writing covered calls each month. "It aims for stock-like returns but bond-like volatility," says CBOE vice president Matt Moran.
Over 10 years through November, the BXM returned 4.2% a year, versus 2.9% for the S&P 500. Over 20 years, which counts the go-go 1990s, its lead is narrower: 8.4% versus 8.3%. During both periods its volatility was significantly lower than that of the S&P 500.
Investors can buy into the BXM index through the PowerShares S&P 500 BuyWrite Portfolio (PBP),
Investors shouldn't overestimate the safety such funds confer, says Ilya Figelman, an analyst with AllianceBernstein, since they only slightly outperform during a crash.
Then again, an investor who can't take risk shouldn't be in the stock market in the first place, Mr. Figelman says.—Jack Hough is a columnist at SmartMoney.com. Email: email@example.com