A less risky form of options contract

`Covered calls' are used to counter high market volatility

in such a deal, a buyer pays for right to buy a stock at a set price

Your Money

August 22, 2006|By JEFF BROWN | JEFF BROWN,THE PHILADELPHIA INQUIRER

The problem: You have a stable of stocks that aren't going anywhere and you're tempted to sell to shift the proceeds to a nice, safe certificate of deposit earning a tidy 5 percent or so - three times the rate of a couple of years ago.

But selling those stocks might trigger a capital-gains tax. And it would mean putting that cash on the sidelines, defying all the experts' claims that stocks are the most profitable long-term investment.

If only there were a way to squeeze a little more return out of those stocks without dumping them.

Perhaps there is - by writing "covered calls," a type of options contract that, unlike many other options bets, is considered a relatively conservative strategy.

"We're definitely seeing more and more of it," said David S. Kalt, chief executive of online options brokerage OptionsXpress.

"It's not that it's a new strategy. ... I just think people are getting more and more comfortable with it as people are becoming more self-directed," he said yesterday.

This year's market conditions have been especially suitable for writing covered calls, Kalt said. The broad market indexes are little changed since the start of the year. But there have been periods of relatively wide but temporary moves - high volatility that pushes options contract prices upward, making call writing more profitable.

Covered calls are not for everyone, and there are risks. Still, even the most cautious buy-and-hold investor should know how they work.

An options contract gives its owner the right to buy or sell a block of stock - 100 shares per contract - for a set price anytime over a given period of days, weeks or months. A "call" is the right to buy shares; a "put" is the right to sell them. There also are options on exchange-traded funds - mutual funds that trade like stocks.

A person who writes a covered call promises to sell shares at a set price if the call's buyer chooses to exercise his purchase option. These are called "covered" calls because the writer already owns the shares he's promising to sell.

Imagine you owned 1,000 shares of Microsoft, which yesterday traded about $24.50 a share. You could have written a call promising to sell for a $25-per-share "strike price" anytime through mid-January. The person buying the call would pay you a $1.25-per-share "premium" for that right - a total of $1,250 for the right to buy stock later.

If the share price rose and the call owner exercised his right to purchase, you'd sell for $25 a share. Since you had also pocketed the premium, it would be like getting $26.25 per share.

If the share price did not rise, the call buyer would not exercise his option, because he wouldn't want to pay you $25 a share if he could get them for less through his broker. You'd still have the shares, plus the $1,250 premium (and any dividends paid during the time involved). The premium would be like earning 5 percent on your holding over five months.

Since you'd still have the shares, you would profit from any future price gains.

The downside, obviously, is that if Microsoft soared, you'd end up selling for $25 when you might have gotten much more if you hadn't written the call.

So writing a covered call makes sense only if you'd be satisfied with the sales price plus premium, or if you're confident the price won't go up enough for the call's buyer to exercise.

The risk of having to sell - being "assigned" - can be reduced by writing a call with a higher strike price, though the premium will be lower because the call buyer would have less chance of making money.

To trade options you must be approved by your broker. Commissions vary but can be quite low. OptionsXpress charges just $15 to write 10 contracts.

For more on covered calls and other options strategies, go to www.888options.com. Also check out the virtual trading function under the toolbox tab at www.optionsxpress.com.

brownj@phillynews.com

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