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The Two Faces of Volatility

“Remember that there are two varieties of volatility. Downside volatility is the type to avoid, not generally upside volatility,” Craig Israelsen writes in Financial Planning magazine. Far from doing everything possible to avoid volatility, we should all want portfolios that have higher levels of upside volatility, Israelson asserts. Traditionally, one advantage of building a broadly diversified portfolio is reduced volatility of returns. When higher standard deviation results in impressive upside performance, that is hardly something to be upset about, he observes.

The SPDR S&P 500 (NYSE symbol SPY), the most widely traded contract on option exchanges, provides a vehicle for building a broadly diversified portfolio, because underlying the SPY contract is the Exchange Traded Fund, which is in turn based on the 500 stocks composing the S&P 500 Index. Incorporating SPYs allows a broad spectrum of investors the opportunity to take advantage of that broad diversification while yet taking advantage of upside volatility.

Sheaff Brock Managing Director Dave Gilreath has an interesting observation about the term “volatility.” Ever since Harry Markowitz published his 1952 paper on Modern Portfolio Theory, he believes, investors have thought of the two words “volatility” and “risk” as being synonymous. They are not, he stresses; in fact, they are two totally different things. Since the early 90s, Gilreath explains, analysts have measured market volatility by the VIX. This a thirty-day, forward-looking measure of the volatility in the S&P 500 stock index as determined by option premiums. In other words, the VIX is a predictor of movement (up OR down) in the stock market in the next thirty days.

In keeping with the Israelson concept of seeking higher upside performance utilizing volatility, the Sheaff Brock Index Income Overlay portfolio is a long-term, bullish play on stock investing using the SPDR S&P 500 ETF. This strategy makes use of put credit-spread selling, using an existing portfolio as collateral for the options account. It is intended to capture long-term time premium by leveraging market-diversified risk over an underlying portfolio.

The Sheaff Brock Covered Call Income strategy invests in a diverse portfolio of high-quality stocks and writes/sells short-term out-of-the-money call options. The overall aim is to generate consistent income in the form of call option premium in addition to the capital appreciation of the underlying high-quality stocks.

As the Options Industry Council (OIC) explains its goal, it is to “provide a financially sound and efficient marketplace where investors can hedge investment risk and find new opportunities for profiting from market participation.” And as Sheaff Brock Director Jim Murphy explains one of the firm’s goals on behalf of its clients, it is helping them take advantage of upside volatility!

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