In the firm's alpha strategy, that range is split in half to target 10% price movements in any given six-month period. "Instead of buying SPY, we structure an options call spread on the ETF at current prices," said Herrell.

The process involves taking advantage of gains made from initial strike prices on those option calls. (A strike price is simply the point at which an investor is going to start making profits. If SPY is selling for $85 per share, for example, and someone buys a call option on the ETF at that level, then an investor makes money on any price gains.)

"It's like leasing an ETF for a certain period," said Herrell.

While it still provides upside participation, using call spreads reduces downside risk, he says, "because you're risking fewer dollars since the cost of the options is much less than buying the ETF itself."

Herrell adds that even in a worst-case scenario, "the most you can lose is the cost of the spread" using such a strategy.

The firm also sells short-dated options. In terms of buying activity, Herrell sticks to purchasing only longer-dated options.

Self-Funding Approach 

"Even if the market doesn't go anywhere, the shorter-term options expire, and you'll make at least a little money," said Herrell. "The net result is that as time passes, this sort of time-decay pays for the upside participation. So it's a self-funding approach which limits your downside but participates in a market advance."

The other aspect of his portfolio strategy actually involves purchasing shares of ETFs outright. Currently, besides owning SPY, some of Partnervest's portfolios include: iShares Russell 2000 Index (NYSE Arca: IWM); iShares MSCI EAFE Index (NYSE: EFA); iShares MSCI Emerging Markets Index (NYSE: EEM) and iShares Dow Jones U.S. Real Estate (NYSE: IYR).

Owning actual shares of the ETFs is part of his Volatility Enhanced Global Appreciation strategy, or VEGA. In such a portfolio, Herrell will also sell call options on a portion of those ETFs to lock in returns.

"We're swapping a potential return for a fixed return," he said.

Partnervest has developed algorithms and built its own quantitative modeling system for constructing portfolios along those lines.

"It tells us how much of an ETF to buy and when to buy and sell options and at what prices," said Herrell. "Rather than guess, we have the model that dynamically adjusts to changing market conditions based on historical volatility patterns and returns."

-- This article was submitted by IU.com's Murray Coleman.

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