January 15,
2002

Getting
Going

Some Stock-Option Strategies
Win a Guarded Endorsement

By JONATHAN CLEMENTS

Staff Reporter of THE WALL
STREET JOURNAL

Let's start with a concession: Maybe options aren't totally devoid of
merit.

I don't like exchange-traded stock options. They are complicated. They are
often used for mindless speculation. And the odds are unattractive. For every
winner, there is a loser. In fact, after trading costs, investors collectively
end up out of pocket.

Still, I did manage to find two options strategies that almost pass muster.
Options come in two flavors: puts and calls. By buying a put, you acquire the
right to sell stock at a fixed price. Similarly, by purchasing a call, you
acquire the right to buy stock at a set price.

But these rights don't come cheap. You have to pay a premium to the sellers
of these options. Indeed, many folks sell puts and calls as a way of generating
extra investment income. But that strategy can backfire if the stock involved
has a big move.

Sellers of call options may miss out on big gains by the underlying shares,
while sellers of puts can be forced to pay a lofty price for a now-battered
stock.

Sound confusing? To get a better handle on what is involved, consider these
two strategies that may appeal to certain investors.

Easing out: Suppose you have 1,000 shares of Microsoft that you
bought for a pittance. You know you ought to diversify, but you are reluctant to
sell because of the resulting tax bill.

Options could ease the pain of selling. The idea is to write call options
against your Microsoft position. Let's say you sold July calls, with a $75
strike price, somewhat above the current $68.47 share price. By writing the
calls, you agree to sell your Microsoft shares for $75 any time between now and
the options' expiration date. In return, you will receive $4,200 in option
premiums, which will help to offset the tax bill, should your stock get called
away.

"The problem is the downside," says Eric Seff, a financial planner in
Mamaroneck, N.Y. What if your Microsoft shares plunge? Mr. Seff says the option
premiums you collected probably wouldn't compensate for your losses.

To guard against a big decline in Microsoft's shares, you could combine the
sale of call options with the purchase of Microsoft puts.

That would give you downside protection. But the premium you pay for the puts
will likely wipe out the income you earned by selling the calls.

What to do? Maybe you should forget the puts and instead sell calls with a
strike price very close to today's share price. For instance, you could sell
Microsoft calls with a strike price of $70, just above the current stock price.
That way, you will earn some extra income, while being almost certain that the
options you sold will be exercised and thus your Microsoft stock will get called
away.

Or maybe you should just dump the shares. "If you know you should get out of
the stock, then get out of the stock and forget the options," advises
Minneapolis financial planner Ross Levin. "The taxes may hurt. But that's the
price of good investment choices you made in the past."

Looking Down: What if a bear market hits when you are retired? If you
are already a few years into retirement, you are probably in fine shape, thanks
to the cushion created by earlier investment gains. But if you have just
retired, you could find yourself in deep trouble, as your portfolio is rapidly
depleted through a combination of tumbling stock prices and your own
withdrawals.

To protect yourself during the critical first few years of retirement, you
might buy put options, says Moshe Milevsky, a finance professor at York
University in Toronto and author of "The Probability of Fortune."

Suppose you bought puts on the Standard & Poor's 500-stock index that
expire in December and that will limit your losses during the next year to 8%.
This insurance will currently cost you about 5% of your stock portfolio's
value.

Sound like a heap of change? To pay for this downside protection, you could
sell call options. But those calls will limit your potential gain. To earn
enough to pay for the puts, you would probably have to write calls that cap your
stock-market earnings during the next year at 8%.

That would be a big mistake if your first year of retirement turns out to be
a gangbuster year for stocks. "If you are worried about the upside, sell a call
at a higher strike price and finance part of the put out of your own pocket,"
Prof. Milevsky suggests.

Because these calls with a higher strike price won't generate as big a
premium, protecting against a one-year market decline of greater than 8% might
cost you 3% or 4% of your stock portfolio's value. For antsy investors, that
might be money well spent. But I would rather keep the cash and take my
chances.

Write to Jonathan Clements at [email-masked]

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