When financial markets experience wild price swings, as we’ve seen recently, it is easy to become paralyzed with inaction — or make emotional, ill-timed moves within your portfolio. Even worse, the hyperbolic financial media often fans the flames of uncertainty.

But rather than cashing out at what could be an inopportune time, you may want to consider employing a creative, specialized strategy that can help you mitigate the impact of market declines in your stock portfolio and perhaps even enhance your returns over time.

Adjust Your Expectations

Perhaps the first step in removing emotion from your decision-making should begin with a realistic assessment of future investment returns. The graph below shows that stock market returns aren’t what they used to be. Unlike the double-digit average annual returns during the 1980s and ‘90s, this century has so far ushered in a rude awakening for investors — with stocks posting a negative 9 percent total return in the 2000s.¹

And the rough ride has continued, with big up and down swings in 2010 and so far this year, producing total price appreciation of just 1.5 percent for the S&P 500.²

Keep in mind this is a measurement of the broader market returns. Our take away here is that you can’t count on big gains from owning index funds alone in this environment and that investing in stocks requires a more selective approach.

Even though the broader market has fared poorly over the last decade, many individual stocks have bucked the trend. What it all comes down to is your individual asset allocation, stock selection, and above all your willingness to be opportunistic in volatile markets.

Our view is that an actively managed stock portfolio of high-quality, dividend-paying stocks may be a more prudent strategy to follow in today’s uncertain markets rather than a simplistic buy and hold approach.

Meanwhile, if it’s suitable with your objective and risk tolerance, you may want to consider a more creative approach to your equity portfolio that can enhance your total return potential…

Consider ALL Your Options

One way to potentially make your existing equity portfolio work harder for you is to incorporate a stock option strategy.

Some investors shy away from options because they are considered speculative. But when used appropriately as part of a disciplined approach, options can be a valuable tool to help reduce overall volatility and earn additional income on your equity portfolio.

At Banyan Partners, in our managed option portfolios, we use options in a variety of ways.

One strategy is to write (sell) covered calls on stocks you already own in your portfolio. This strategy may be used in any market conditions, but is often most effective when markets are volatile and your stock is in a trading range.

Rather than speculating on the stock price by purchasing a call option, we’re taking the defensive side of this transaction by selling the call option to another investor. In this case, the speculative nature of options can potentially work in your favor.

The primary goal of this strategy is to provide 4 to 6 percent additional premium income over and above any dividends you already receive from your stocks. However, the strategy does not offer protection from a significant stock price decline.

Let’s walk through a hypothetical example to help illustrate how covered calls work...

Last year, Celgene (NASDAQ: CELG) was trading in a range between roughly $50 and $60 per share. The shares were bouncing up and down along with the market.

In mid-May 2010 (see #1 in the graph below), assuming you owned 200 shares of CELG, you could have sold the June 2010 $60 Call Options covering half your position, or 100 shares, earning a premium of a bit more than $2 per contract. The extra income earned in this example is equal to nearly 4 percent on the value of Celgene stock, which was trading at just under $60 at the time. See the table below for the trade details.

Just over one month later, when Celgene shares pulled back in price, the call options would have expired out-of-the-money, meaning you would have kept all of the premium income earned.

In early June 2010 (#2), with Celgene still range bound, you could have sold the July 2010 $55 Calls, covering your other 100 shares of stock and earning $1.29 per share in additional premium income or about 2.5 percent of Celgene’s stock price of $55 at the time (see table below).

As shares continued to bounce around in early July, with the price of the calls now changing hands at about 25 cents on the dollar (#3), you could have decided to either wait for expiration or to close out the position early and take the potential gain. (Closing the option contract early would require a purchase, the cost of which would reduce the amount of premium income received from the initial sale of the call.)

This illustrates the potential of a systematic covered call strategy. While Celgene shares bounced around in a narrow range over a two-month period, it was possible to earn extra premium income on the stock by writing covered call options.

The above table assumes that that the July $55 call was allowed to expire and not closed out.

Of course, not every covered call investment shows results like this. There are risks to writing covered calls. For example, if the stock you’re writing calls on moves substantially higher, you could be called away, meaning you’re obligated to sell your shares at the option strike price, which could be significantly below the then current market price.

Still, if used systematically and on a recurring basis, strategic covered call writing has the potential to enhance your portfolio income over time.

Writing covered calls on a recurring basis for your stock holdings is just one way to be more opportunistic with your equity portfolio. You can also use options as a way to mitigate the downside risk to your portfolio.

A defensive strategy you can employ would be to buy put options on stocks you own. The cost of the puts will reduce your upside price potential by the amount of the premium that you pay, but the benefit is gaining some protection against an unexpected decline in the stock price. Buying a put allows the investor to sell the underlying stock at a stipulated price (“strike price”) at any time before the option contract expires.

Think of it as the price to pay for a bit of “insurance” on your stock or your portfolio.

Another variation is to write defensive covered calls at the same time you buy a put, creating a “collar” on your stock. The premium income received for the call can offset some, or perhaps all of the put option cost, lowering your “insurance premium.”

As you can see, there are many creative ways to use stock options within your equity portfolio to compensate for changing market conditions. For instance, in our Banyan custom option overlay we also invest tactically in options, frequently using both puts and calls in combination.

Option strategies may not be the right fit for everyone and we don’t recommend investing in puts and calls on your own without first educating yourself fully about all the risks and rewards of options. If you are interested, we highly recommend the Options Industry Council as a great place to start for a basic education on the advantages and disadvantages of options, including tax implications and information about many other option strategies you can use within your equity portfolio.

To learn more about how Banyan Partners uses option strategies in the equity portfolios we manage, you can receive our just-published Banyan Option Kit, which provides more detail about the professional stock option strategies we employ for qualified clients at Banyan Partners. Go here now to learn more and download a free copy of the kit right away.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Fidelity Management & Research, as of 12/31/09
² Bloomberg market data, 10/13/11