2 Tools to Profit in a Slow Market

What's your favorite stock?

Seems like such a simple, harmless question, right? But suggesting the one perfect stock that's good for any portfolio is a pretty tall order. It's no wonder Warren Buffett takes a pass on throwing out individual stock ideas.

While it's fun to trade individual stock tips and track their daily fluctuations, it's better to look beyond individual stock performance and focus on constructing market-beating toolboxes.

Huh? What's a toolbox got to do with investing?
Every investment is a tool designed to help us earn our desired returns. The combination of all of our investments -- our portfolios -- shows us what tools we really have in our toolboxes.

Just as a man with a hammer sees everything as a nail, having only stocks in our portfolio toolbox limits our ability to tackle uncooperative markets. That's why it's important to fill your box with the kind of gear that can keep your profits humming.

ETF power                               
One increasingly powerful tool is exchange-traded funds (ETFs). What are ETFs? Simply put, imagine that a mutual fund and a common stock got together and had a baby.

Like mutual funds, ETFs can offer investors both broad and narrow exposures to specific industries, sectors, or investment strategies. However, since they trade like stocks, ETFs are also an accessible, liquid, and tax-efficient way to plug those holes of fear in your portfolio.

Interested in emerging markets? Maybe the iShares MSCI Emerging Index Fund (NYSE: EEM  ) or the Vanguard Emerging Markets ETF (NYSE: VWO  ) is for you. Oh, I'm sorry – you'd actually prefer to make a concentrated bet on South Korea? Then you might want to consider iShares MSCI South Korea Index (NYSE: EWY  ) .

OK, ETFs might be a great way to diversify and an easy way to gain exposure to very specific types of investments, but they can't give you the flexibility of active management ... or can they?

While the vast majority of the $1 trillion in ETF assets are in passive funds, there is a growing number of mutual fund-like structures, called actively managed ETFs, making their way to market. The majority of funds are flowing to bond-centric funds like PIMCO Intermediate Muni Bond Strategy ETF (NYSE: MUNI  ) . So now, no matter what you want in an ETF, one's available.

Options opportunities
While options can appear to be scary at first, they're probably one of the most underused tools for cautious investors. While the lion's share of reporting on options tends to focus on the more speculative trades, there are numerous strategies well-suited for the conservative investor.

One popular options strategy involves writing covered calls. In this scenario, you own shares of a company that you believe in but that you also think will be stagnant going forward. You can write calls on the stock for a predetermined sell price. That gives the buyers of those calls the right to buy them from you at that predetermined price while the option is current.

If the price goes above the target price, you're obligated to sell at the predetermined price, and you forfeit any profits above it. However, you've already earned a little more through the calls themselves, offsetting any forfeited gains.

If the price stays steady, you keep your shares as well as the income the calls generated.

In other words, covered calls are the ideal tool for investors who want to essentially lower their cost basis on stagnant stocks in their portfolio.

Making stocks pay dividends
Covered calls can also be used to goose the near-term payout of stocks you already own or make stocks that don't pay dividends synthetically do so.

Take, for example, shares of Vodafone Group (Nasdaq: VOD  ) , which currently pay a 3.2% dividend and trade just below its 52-week high. The company has been on a run as of late and sits on a valuable, but unmonetized, 45% ownership of Verizon Wireless. At current prices, the stock is neither a screaming buy nor sell. Assuming shares stay range-bound over the year, writing (selling) a January 2012 $30 call could reap you an extra 5% payout on top of the dividends the company already pays you.

Or what about Cisco Systems (Nasdaq: CSCO  ) ? Although the stock hovers just above its 52-week lows, this networking giant has better days ahead. Assuming you don't mind potentially having the stock called away from you, selling a January 2012 $22.50 covered call would create a payout of more than 7%.

The Foolish bottom line
We don't advocate using ETFs or options to speculate, but we believe investors can use them intelligently to help create a portfolio that is relatively resistant to the market's temperamental whims.

How do we know? Jeff Fischer and company at Motley Fool Pro have built a ridiculously impressive track record using stocks, ETFs, and options -- they've posted better than 38% returns with just half of the S&P 500's volatility. If you'd like to find out more about ETF and option strategies for growing your wealth in a volatile, range-bound market -- just enter your email address in the box below.

This article was originally published June 16, 2010. It has been updated.

Andy Louis-Charles is an equity analyst for Inside Value, Special Ops and also manages the ALOHA real-money portfolio. Vodafone Group is a Motley Fool Inside Value selection. Motley Fool Alpha owns shares of Cisco Systems. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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