February 2, 2009

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Article

Stock Options

Making Money Still Possible in a Volatile Market

William Wallace

February 2, 2009

After the last 12 months, investors have a greater understanding about the risks involved with investing in stocks. Perhaps we have all realized that we do not have as much tolerance for risk as we thought we had. In particular, those nearing retirement have gained renewed appreciation for owning fixed income investments and living debt free. Some may be questioning whether stocks should be included in their investment portfolio at all, which I would answer yes, but that’s an issue for another day. So how can one go about making money or preserving what he or she has in a volatile market like the one we are witnessing today? Investors should consider using call and put options or structured notes to help reduce the risk of their current investments through broader diversification, and to potentially increase returns. Call and put options can be used to either speculate on the moves in the market or to hedge your investments against a decreasing market. A call option gives you the right, but not the obligation, to buy an investment in the future at a price agreed upon today. Conversely, a put option gives you the right, but not the obligation, to sell an investment in the future at a price agreed upon today. Call and put options have been used by stock market investors essentially since markets first came into existence. Structured Notes are prepackaged investment products that use puts and calls to hedge and/or speculate on stock market moves. Investors should consider investment strategies that are designed to reduce your investment risk and be additive to investment returns. Return Enhancement An effective way to enhance investment returns is to sell calls on your stock positions, or in some cases, an exchange traded fund (ETF). For example, a strategy that we have used for clients of Key Private Bank is to sell calls on shares owned in the SPDR Trust Series 1 (ticker: SPY) which is an ETF investing in the S&P 500 stock index. Typically, when we sell the call option we do a 30-day transaction. By selling the call, we forfeit most of the potential upside of the fund, but in return, we receive income that can enhance the return of an overall portfolio. If you get into the habit of selling a call option every 30 days, you will increase investment income and modestly reduce your downside risk. For example, in a recent transaction a client owned 1,000 shares of SPY and we sold a 30-day call that generated $2,950 in premium income. Risk Mitigation In addition to providing current income, selling calls on your stocks or ETFs can also act as a modest hedge in your portfolio in a decreasing stock market environment. However, a more effective way to hedge your equity exposure is to buy put options on individual stocks or ETFs. When you buy a put option you are protected against decreases in the value of the stock market beyond a certain point. Buying a put option is like buying insurance and it will cost you a premium for the market protection. Some strategies include simultaneously selling a call and buying a put, known as a “collar” transaction. In this case, selling the call will provide the funds to buy the put. A collar transaction can be particularly effective when working to protect a large single stock position. The Bottom Line Even in a volatile market environment, there are strategies that can be used to improve the overall results of your investments. Using call and put options and structured notes provide ways to enhance returns or mitigate your risks. As with any investment strategy, you will need to determine if you want to attempt it yourself or hire a professional advisor. Also consider the tax ramifications of using calls, puts and/or structured notes in your portfolio with your tax advisors. William Wallace is senior vice president and regional portfolio manager at Key Private Bank. He can be reached at William_W_Wallace@Key.com.
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