Question

A conservative customer wishes to use an options strategy to generate income against his entire equity portfolio, which consists mainly of a diversified mix of blue chip stocks. To do so, the customer could:

Answer 1

Sell OEX 100 Calls

Explanation:

For income, the customer must sell options. If the customer sells S&P 100 Index (OEX) Calls, the customer will earn premium income if the market stays flat or declines. The premium earned will help offset any loss on the stock portfolio. If the market rises, the calls will be exercised, but the loss on the exercise of the calls should be offset by the increase in the value of the stock portfolio. Thus, this is a conservative income strategy.

The VIX option value is not based on stock price movements - rather it is based on price volatility. It is negatively correlated to the market. If the market declines, volatility increases and the VIX increases in value. The VIX calls would be exercised. The customer would lose on both the short VIX option positions and the equity portfolio. So this strategy has greater risk potential in a down market than selling S&P 100 index calls. On the other hand, in a rising market, volatility decreases. The short VIX option will lose value and will likely expire. The customer will keep the premium and will enjoy the rise in value of the equity portfolio as well. So for the greater risk assumed in a down market, the investor has greater gain potential in an up market.

Since this investor is "conservative" and is seeking income, the sale of the OEX Calls is the better choice since it is lower risk.