NEW YORK (TheStreet) -- One year ago, fund provider ALPS launched the High Volatility Put Write Index Fund (HVPW) as a first-of-its-kind fund that sells, or writes, cash-secured naked put options. It is still the only fund whose primary strategy is put writing.
Selling cash-secured puts is basically a fairly conservative income strategy that works best in flat or rising markets. The word naked refers to the puts -- which is a right to sell a security at a specified price, known as the strike price, within a certain time -- being sold with no corresponding short sale in the underlying equity, and cash secured refers to keeping enough cash on hand to pay for the stock if the put option is assigned.
The biggest risks occur in a falling market or if puts have been sold on a stock that goes down a lot. Put selling would not be an appropriate strategy for anyone who believes the market is at a top.
The worst-case scenario is being forced to buy a stock at the strike price after it has fallen well below that strike price in the open market. I wrote about the mechanics of this strategy in greater detail when HVPW first launched.
Specifically, HVPW will sell put options that are 15% out of the money on 20 stocks that tend to have high-volatility readings. The higher the volatility of a stock, the greater the option premium received in the put sale should be. Premium is the cost of the option. Buyers pay the premium and sellers receive the premium.
The fund sells options in 60-day increments and targets a 1.5% payout to fund holders, with the net premiums available for distribution every 60 days. That extrapolates to 9% a year.
Kevin Rich, HVPW's subadviser, notes that in most 60-day cycles the premiums taken in by the fund are closer to 3%, but the fund keeps any excess premium for occasions where the fund is assigned early or otherwise has a trade go against it.
The year in which HVPW has been trading was an ideal market for put selling. In the last year, the S&P 500 is up 21% and has not had as much as a 10% correction. Luckily for fund holders, 109 of the 120 puts sold in HVPW's history have expired worthless; worthless at expiration is the ideal outcome for an options seller.
When the next bear market comes around, the put-selling strategy will seem less conservative. It is widely accepted that a bear market is defined as a 20% decline from the high, but of course many markets have gone down more than 20%; the last two bear markets saw drops of 50%. Volatile stocks such as the ones used in HVPW's strategy could easily go down more than the market.
There will be some cushion as HVPW sells puts that are 15% out of the money, but the stocks in HVPW tend to go down a lot in the face of bear markets and occasionally just on bad news.
The fund just turned over its portfolio with the option expiration that just occurred over the weekend. One of the stocks in the portfolio for the next two months is Best Buy (BBY) - Get Free Report, which during the last bear market fell 65% from its peak to its low.
Despite the volatile nature of the stocks that the fund writes puts on, the fund itself has had very little volatility, which is the objective along with the high income.
The yield and volatility profile make HVPW a bond market substitute if and when interest rates start to rise, but investors will need to maintain a strict sell discipline while holding the shares.
At the time of publication, the author held no position in the fund mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.