Is Now the Right Time to Try an Options-Based Fund?

And the Oscar for "Strategies that Outperform the Market with Lower Volatility" goes to … options-based strategies! That's the conclusion from a white paper here, as described by Tom Lydon at ETFTrends:

"The white paper analyzed 80 Options-Based Funds focused on U.S. equities, including ETFs like the Powershares S&P 500 BuyWrite Portfolio (NYSEArca: PBP), the largest covered-call ETF based off the S&P 500; the Horizons S&P 500 Covered Call ETF (NYSEArca: HSPX), which also employs a covered call strategy on the S&P 500; the First Trust High Income ETF (NasdaqGM: FTHI), which writes covered call options on the S&P 500; the First Trust Low Beta Income ETF (NasdaqGM: FTLB), which buys put options on the S&P 500 and writes covered call options on the same index; the Recon Capital NASDAQ-100 Covered Call ETF (NasdaqGM: QYLD), which provides a covered-call strategy that targets Nasdaq-100 securities; and the ALPS U.S, Equity High Volatility Put Write Fund (NYSEArca: HVPW), which sells two-month 15% out-of-the-money put options on 20 diversified stocks with the highest implied volatility.

…From 1988 through the end of 2014, both the CBOE S&P 500 PutWrite Index and CBOE S&P 500 2% OTM BuyWrite Index generated higher returns and lower volatility than the S&P 500 Index, according to the white paper. The strong risk-adjusted returns are attributed to the richly priced options."

I emphasized that last sentence because it reinforces a point we make here all the time. Options are almost always overpriced relative to realized volatility. And that's true whether you look backwards at realized volatility, or offset "time" and compare forward-looking implied volatility to the volatility ultimately realized over that time frame.

Thus, it makes sense that a dedicated options-selling strategy works over a long stretch of time. The issue, of course, is over shorter time frames. A poorly timed options-shorting strategy can put anyone out of business in a heartbeat.

But alas, that's not really a relevant point here. We're only comparing the returns of an index versus an index with options sold on top of it in some form. If you stumble on an accident, the option sales actually augment performance … or, at least, they make it not as bad. If the market implodes, at least you get that monthly income via the options sales. The real risk of those sales is that it costs you upside.

But let's face it, how often does the market rally so swiftly that the opportunity cost of the overhead calls becomes painful? Not that often, in my humble opinion. The tech bubble was about the only time in the last 25 years where the market rose on consistently rising volatility.

And all of that highlights the second important takeaway of all this: These exchange-traded funds (ETFs) all reduce portfolio volatility. On the surface, that makes no sense. How can selling volatility reduce volatility? Very simply -- as we just noted, it reduces losses into dips and cuts off gains into rips.

The trick to adding value here is in the timing. Is now a good time to switch into an options fund like those described above? Probably yes. Even though volatility is "meh," it overprices realized volatility at slightly elevated levels. Remember, we're comparing stock fund to stock plus options fund here, not commenting on allocating out of stocks altogether. And the relative attractiveness of buy-writing is decent here, when put in that context.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.