Most of the mutual funds go long (buy and hold) on the stocks. Some of them short the stocks. Few mutual funds practice long-short strategy meaning that they go long some stocks in their portfolio and short the rest of the stocks.
Traditionally, mutual funds used to buy or short the stocks. They don’t normally play with options. Derivatives like options are the favorite of hedge funds. Mutual funds tend to stay away from the derivatives to reduce the volatility. However, in the recent years some mutual funds were started to adapt the “buy-write” strategy which essentially is writing covered calls on the stocks owned.
What is covered call? If you own a stock, you can write a call option on that stock. You already own the stock, so it is “covered call”. If you write a call option on a stock without owning the stock, it’s called “uncovered call” or “naked call”. Ok, don’t ask me why it’s called naked!. May be because some people lost their cloths by writing uncovered calls. Covered calls are conservative play. Uncovered calls are dangerous, there is literally no limit for the loss if uncovered call option position goes against you.
When you write a call option on a stock, you promise the buyer to deliver the stock at a certain price on or before a specified date. You get the call option premium from the option’s buyer to reward you for your commitment. The buyer wants to buy your call option, because he/she thinks that stock will go up soon. If the stock goes up after you write the covered call you will lose all the upside potential of the stock. If the stock goes down, the buyer of the call option lose the money.
In difficult times like the one we currently face, writing covered calls on the stocks you already own would be a prudent thing to do. Covered calls are also known as “buy-write”. Some mutual funds offer funds that use covered call strategy to reduce the volatility of the portfolio. Risk managed equity option income fund (EROAX) from Eaton Vance is one of them. This fund seems to weather the storm of the recent weeks compared to S&P 500. See the chart below for the comparison.
Disclosure: I do not own the mutual funds mentioned in this post.
If you like this post, check out the part-2 of this post.
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[...] post is an extension of Mutual funds that use covered call strategy that was published on Dec 2, 2008. Here are some more mutual funds that use covered call strategy [...]
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