New Fund Offers Cash-Secured Naked Put Options

TheStreet.com

NEW YORK (TheStreet) -- Yesterday, innovative ETF provider ALPS launched the High Volatility Put Write Index Fund HVPW . The strategy underlying the fund is to sell cash-secured naked put options on volatile large-cap stocks to generate an income stream for fund holders.

Selling or writing naked puts is a strategy that succeeds when the underlying stock stays flat or goes up. The risk to the strategy is a large decline in the stock. For example if a stock is trading at $70, an investor might sell a put option with a $65 strike price in exchange for option premium.

If the puts expire and the stock stays at $65 or higher then the puts expire worthless and the investor gets to keep the premium with no other action to take. If the stock goes below $65 before the puts expire, then the investor will very likely be assigned on his put options which means he will have to buy the stock at $65. If the stock is at $64, then it isn't a nightmare but if the stock has dropped to $30 or $40, then being forced to buy at $65 would be a nightmare. That is the risk of the strategy.

More specific to HVPW, the fund will maintain a portfolio of puts sold against 20 volatile stocks. It will sell options that expire in 60 days that are roughly 15% out of the money, and so be able to repeat this six times during the year. The income component will come from the premium brought in from selling the puts. HVPW will seek to pay out 1.5% every 60 days, a 9% yield.

However, before the fund can pay out the 1.5%, it will have to account for the expense ratio of 0.95% annually. Also, any losses from losing put trades will also come from the potential 1.5% income stream.

In an up market, selling puts usually works very well. The next time there is a large decline though, the fund could get hit very hard. Remember that the fund sells puts in two-month increments.

As an example, in one two-month run from August 2008 to October 2008, Apple AAPL dropped from $175 to $100. With the stock at $175, the fund, if it had existed in 2008, might have sold puts with a $150 strike price, which at expiration would have worked out to a $50 per share loss. That loss would have negated one payment entirely and taken a bite from the subsequent payment.

(Keep in mind that was just one stock. In late 2008, it is likely that the majority of any group of 20 volatile stocks would have had large losses which could have wiped out many payments.)

Actual names in the fund currently include Netflix NFLX , Green Mountain Coffee Roasters GMCR and Best Buy BBY , which speaks to how volatile the underlying stocks are.

HVPW is not a bad fund, but it would likely not be a name to hold in the face of the next bear market.

At the time of publication, the author had no position in any of the holdings mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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