Jun 1, 2005 12:00 PM

, By Andrew M. Parker, director of equity risk management, Bessemer Trust, New York

By Andrew M. Parker, director of equity risk management, Bessemer Trust, New York

Ever since stock options were listed on the Chicago Board Options Exchange in 1973, the most popular and widely practiced option strategy has been “selling covered calls” against stock holdings. On the surface, it can be a very compelling strategy. But it's imperative that this investor fully understand the value of the options he's selling. On a single investment, the investor can profit by selling an undervalued option; but over time, selling options too cheaply will lose money. It's also very important to understand how this strategy impacts the investor's overall portfolio. If he's taking a risk with potential losers yet capping potential winners, his portfolio's expected return will drop. A covered call, then, is a good strategy only if an investor makes sure he's fairly compensated for accepting this lower expected return.

A “call option” is, of course, the option to buy a stock at a predetermined price (“strike price”) until a predetermined date (“expiration date”). For example, at press time IBM was trading at $83.50 per share. The option with a strike price of $90 and an expiration on the third Friday of January 2006 costs $3.50. Why buy an option rather than just the stock? The reason is primarily due to risk tolerance. The buyer of the option may have a lower chance of return, but he also takes a much lower level of risk — only $3.50 per share. (For the record, a “put option” is the option to sell a stock at a predetermined price — but we'll save “puts” for another day.)