One of the best advantages with adding options to a portfolio is the ability to hedge systemic as well as positional risk. This gives you the ability to add diversification, reduce risk, and sleep better at night.
So I went ahead and designed a "poor people" portfolio. Here's the rundown:
MCD: I eat there all the time. (200 shares @ 62.93)
KO: I need something to drink with my Big Mac (1 May 09 55 Call @ 4.40)
WMT: They have both! (500 @ 60.75)
PSA: I need a place to put all the stuff I bought at WMT (100 @ 90)
COH: I never shop there so they're going bankrupt (2 Jan 09 22.5 puts)
Here's what the portfolio risk looks like indexed against the SPY:
You can see that after weighting it against a broad based index, your portfolio is the equivalent of holding about 192 shares of SPY. This is your systemic risk. Of course the reason you bought these positions is because you believe that they will outperform the market over time, but you'd like to reduce your overall market risk. So what can you do?
Sell OTM call verticals. We'll go 2 months out and sell some calls that have about 30% probability of expiring in the money. The Nov 08 119/121 Vert Call Spread is selling right now for .70. Take on 10 verticals (20 total positions) and your risk goes from 192 to 143 a 25% decline from the beginning. On top of that, you're adding on an extra $700 in potential return provided the market stays below 119. You can do a lot better when you time it a little more and sell during a run-up than during a run-down. Here's the new risk profile:
Also, it would make more sense to not establish a full on position but rather put it on gradually. Also, that extra $700 dollars gives you a return:
700 / (111.85 [spy close] * 143.32 [portfolio delta] ) = 4.3%
That means your systemic basis is reduced by 4%. Hope this shows how options can be very powerful as a hedge as well as generating a little extra alpha.