Editor's Note: This is Part 2 in a multiple-part series. Part 1 can be found here, Part 3 can be found here, Part 4 can be found here, and Part 5 can be found here.


I know that being able to find individual stocks that out-perform the market averages is a skill I lack. I haven't made the attempt in years. If you have that skill, more power to you.

The question is: Can using risk-reducing option strategies enhance returns.

I'm looking for an investment strategy that increases my earnings at the same time that it reduces risk. Isn't that what every investor wants to find?

Apparently not. Despite the evidence that using options gives investors (and traders) a better chance to beat the market -- and with less risk -- many shy away from options. In fact, my quest to pique the interest of personal financial bloggers hasn't yet borne fruit.

I'm not interested in only teaching investors who have an interest in options how to take advantage of this excellent risk-reducing; what I'd love to accomplish is finding a way to get average investors -- who have never heard anything positive about stock options -- to adopt option strategies as a method of guaranteeing that their retirement portfolio can survive any market crisis.

The strategy discussed today isn't that effective and can offer no such guarantees. Later in this series, such a strategy will be covered.

The idea of buying options doesn't work for me, and I discourage that strategy whenever possible. But for anyone who buys stock, or takes a passive investing approach and owns shares of broad-based exchange-traded funds (ETFs), there's more than one option strategy that should be considered.

Covered-Call Writing

Today the discussion is on covered-call writing, which involves owning 100 shares of stock and selling someone else the right to buy your stock at a specified price for a limited period of time.

When you do that, you're selling (writing) a call option, for which you are paid a cash premium that is yours to keep -- regardless of whether the option owner eventually buys your stock.

I consider this strategy to be one of the three basic conservative option strategies because it is among the easiest methods for an option rookie to use and understand.

The purpose of this series is to compare the relative performance of various strategies, and data must be available. Fortunately, the Chicago Board Options Exchange (CBOE) has published indexes that measure the performance of the investing methods we want to compare. These are the Buy-Write (a term synonymous with covered-call writing) Indexes.

The first of these to be published was BXM, based on the S&P 500 Index. Today, there's also BXN, an index based on buy-writing the Nasdaq 100 (NDX), and BXR, which is based on writing covered calls on the Russell 2000 (RUT) index.

The methodology for these indexes is the same and can be found at the CBOE site. The methodology involves:
 

Own(ing) a basket of stocks equivalent to owning the index.

On expiration Friday, approximately one hour after the market opens for trading, sell one call option that is out of the money, but closest to the current index price as possible. The call sold expires in one month and is held through expiration, when the process is repeated. There are no adjustments.

Now that we know about these indexes, how did each of them perform, compared with their individual benchmark indexes? This is a direct comparison between a covered-call writing strategy vs. buy and hold for three different portfolios.