This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.
For most investors, nothing's harder to deal with than a volatile stock market. With 300-point gains followed by 400-point losses on a regular basis these days, the market's roller-coaster ride is something that you're simply going to have to get used to -- at least for now.
But as uncomfortable as a jittery market can be, it can also create an opportunity to boost your profits. If you're willing to expand your investing toolbox and use the right options strategies, you can turn volatility to your advantage and potentially grab some extra returns in the process.
Not for the meek? Think again
In the minds of many investors, options are just an example of what got the stock market into the mess it's in. Like the derivatives that Wall Street institutions got into trouble with during the financial crisis, options can provide you with huge amounts of leverage to make big bets on anything from broad financial markets to individual stocks. Guess right -- as those who picked the top in late 2007 or the bottom in March 2009 did -- and you can earn enormous profits. Guess wrong and you'll often lose every penny you invest.
But some options strategies don't require this swashbuckling attitude. For conservative investors, writing options instead of buying them gives you a great benefit: getting paid for something that you might well be inclined to do for free. And you get paid more in crazy markets like the one we're in.
2 ways to write your way to profits
Just as options come in two different flavors, you have two basic strategies to write options. Writing put options lets you get paid in exchange for committing to buy a stock at a certain price if the put purchaser exercises the option. That leaves you fully exposed to a cataclysmic drop in the share price, but for those who set price targets to buy shares when a stock price becomes attractive, writing puts has the benefit of paying you while you wait for lower prices.
On the other hand, writing covered calls involves options on stocks that you already own. By committing to sell your shares to the call purchaser at a certain price for a fixed time period, you also earn an option premium payment that's yours to keep no matter what. You may end up having to sell shares for less than their future market price if a stock soars; but again, if you would have used limit orders to sell out anyway, covered calls have the advantage of compensating you for your trouble.
So how much can you earn from these strategies? You have a lot of say in determining that, as option prices depend on the share price at which you're willing to buy or sell and the length of time you're willing to keep the option open. Depending on the characteristics you choose, you can add anywhere from a few percentage points per year to several percentage points per month to your returns -- albeit with attendant risks.
But while you have control over those factors, one thing you can't control is the implied volatility of the stock -- and with a jittery market, implied volatilities have been on the rise.
Rules of the road for implied volatility
To give you some more insight into volatility, I turned to the CBOE and its suite of volatility tools. Here are some broad conclusions:
- Stocks in defensive industries tend to have lower volatility than the typical stock. Johnson & Johnson (NYSE: JNJ ) and Procter & Gamble (NYSE: PG ) both have 30-day volatility figures at or below 25%, even with the market's choppiness lately. Low volatility reduces option prices, which means you get paid less for writing options.
- By contrast, stocks that bounce around a lot have much higher volatility figures. With the recent swoon in silver prices, Silver Wheaton (NYSE: SLW ) has implied volatility above 65%, as does Sirius XM Radio (Nasdaq: SIRI ) . The high-profile Netflix (Nasdaq: NFLX ) has an even higher figure of 80%. Those high volatilities make option-writing more lucrative.
Sometimes, even stocks in the same industry have very different volatility figures. For instance, rural telecom Windstream (Nasdaq: WIN ) has implied volatility of just higher than 25% right now. But rival Frontier Communications (NYSE: FTR ) , despite having similar characteristics, is well above 40%.
Get started today
Even the simplest options strategies take some time to get used to. But the simple point is that more volatility means more money in your pocket from writing options. If you expect that volatility to calm down in the coming months, then writing options is like selling a stock for more than it's really worth. As long as you know what you're doing, writing options can enhance your returns without increasing risk.
Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments. Click back to the series intro for links to the entire series.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.