These Funds Use Options to Smooth Market's Bumps

Given the recent volatility of the stock market, who wouldn't relish the opportunity to capture the next big upswing with a "call" option to buy shares at specified prices at some future date?

Conversely, it's pretty tempting to hedge against another major downdraft with a "put" option to sell shares at a specified price.

Puts and calls are extremely risky by nature and are usually not recommended for inexperienced investors. However, there are a number of fund managers who juice the returns of their portfolios -- and buffer them against market declines -- using puts and call. Not by buying them, but by "writing," or creating them and selling them.

Some funds also buy put options to enhance returns, which is a conservative strategy, relatively speaking.

These kinds of strategies are more typical of closed-end funds, but there are also a number of open-end mutual funds that employ them. They are known as option-income funds.

The call options issued by these funds are "covered," in that the funds already hold the shares; otherwise they would be considered to be "naked" -- meaning the funds might be subject to outsized losses.

The proceeds from the sale of covered call options can enhance the incomes of funds. The income can also soften the impact of price declines in the underlying securities.

Even in a flat to modestly upward market, the sale of covered calls is profitable if the price level of the underlying stocks does not exceed an option's exercise price. In such cases, the options expire worthless and each call option's "premium" -- or price tag -- remains with the selling fund.