Steve Regan sends: I don’t recall what my resolution was for 2007, but I’m sure it wasn’t as exciting as call options. I wish it had to do with reading up on bearish views of the subprime mortgage market. Hopefully this year’s financial resolution will bring profit without having to be a prophet. After the hangover clears, I want to add a new tool to my investment strategy and unlock the power of selling out-of-the-money covered call options against stocks in my portfolio.

Remember, a call gives the option holder the right, or option, to purchase the stock from you at a certain strike price before the designated time at which option expires. The buyer of the option will pay you a premium for this right. The cash is yours to keep as long as you hold onto the stock, and if it reaches the strike price the option will be exercised. This limits the upside potential of your investments, but the premium you get in return might be worth it. If you need brushing up on options, Wikipedia and Yahoo! Finance have good articles. In devising my New Year’s Resolution, I am going to consider what drives the market for options and why I want to sell more covered calls in 2008.

The Option Engine

Let’s go by the theory that the irrational emotions of fear and greed drive a large component of supply and demand in the markets. Generally, when life is good on the street traders become hungrier and greed fuels demand. But when the sky appears to be falling, everybody is running for cover and fear is behind demand’s escape. Conveniently, people buy options for two reasons - to hedge against risk (they’re fearful) or to speculate (they’re greedy). Calls are used by speculators looking to cash in big with on a small investment, and by hedgers buying protection from the unlimited downside risk of a short position gone wrong. Investors will pay hefty sums to protect themselves against risk and for the opportunity to get a lot for a little. This is why insurance and gambling are ceaselessly great businesses to be in. Fear and greed.

Volatility and uncertainty spike this demand. And while every era has its uncertainties, 2008 is already poised to be a year of change in the markets and elsewhere. The housing market seems to get worse each day. Will 2008 see the bottom and recovery? How many more billions will banks shed from their balance sheets? Where will the Fed Funds rate have been before 2008 is over? Who will control the White House? The Middle East? China? Will there be recession? A recovery? Millions of ravenous and anxious traders will buy call options with these questions in mind this year. Yet when the dust settles, more than 80% options will expire worthless. The great Warren Buffett refers to the instruments as “time-bombs,” shredding value as time passes until they tick away to zero. But to hedgers and speculators, options are “must-haves” and will continue to be in 2008. So being on the supply side of the options market could be a great way to benefit from that exuberant demand.

Sell the Upside

Let’s dig a little deeper. The essential risk of this strategy is that your stock will be called and you will forego upside to the option holder. To me, this is a no brainer. If you chose a strike price far enough from the current price (which of course will decrease the premium received for the option), you allow a nice gain on the stock before it is called. The upside in excess of the strike price is an opportunity cost risk - there is no risk of cash loss. I know that some people will have trouble swallowing this. If you buy a stock at $5 and are forced out at the strike price of $10 six months later, you couldn’t stand the feeling of watching it go to $85 by the end of the year. Here is how I look at it - (1) $5 to $10 is a 100% gain, and (2) Would you really have held on until $85? Would you still be holding on looking for $100?

This strategy minimizes unknown. Demand for a $100 stock comes from all different types of bets. Some are betting it will be $105 by the end of the year. Some think $110, $125, $150, $200, and so on. If you would be satisfied with 10% this year and think that $150 is out of the question, cash in on the fact that someone out there will gamble on the stock surpassing $150. If you were going to hold the stock anyway the worst thing that can happen is they are right, and you “limit” your gain to just over 50% (including the premium).

Take a more realistic example. You buy XYZ for $50/share. You plan to hold on your several years, but do not foresee outrageous short-term growth. You might get $1 a share for a short-term call with a $55 strike price (of course, this depends on timing and volatility). This table shows how your payout compares to if you had not sold the option as the stock price changes and you sell or hold and stock.

[You may need to scroll down to see the graphic below]

If XYZ goes to $45 and you want out, you have to buy back the option first. Let’s say it will cost you $0.30 (the market is doubtful XYZ will tick above $55 before the option expires). Still this will be less than the $1.00 premium that you received in the first place, shaving a bit off of what would have been a $5.00 loss. The best thing that happens is the stock goes up to $54 ($54.99 or $55, really) on the expiration date. The $1.00 premium is still yours, plus the $4.00 gain on the stock. The option has expired worthless because why pay for the right to buy something for $55, when you can get it for $54 on the open market?

What if XYZ hits $60? This is where you theoretically lose. Your gain on the stock is capped at $5, because the option was exercised at the strike price. Still no one can take that $1.00 from you (unless you use it to buy back to option). True, you would be better off in this case had you not wrote the option and held on. But would you have stayed with XYZ after a 10% jump from $50 to $55 anyway? Perhaps. But to me, treating this type of opportunity cost as a serious risk gets in the way of solid profits. By the same logic, we all wish we had bought Microsoft in 1987. But most of us did not and our portfolios are not down because of it. When the downside doesn’t involve negative numbers, I want in.

Seller Beware

Of course, there are always plenty of good reasons not to sell options. Don’t get me wrong, not all options buyers are suckers. In theory, an efficient market will set the odds so that no one wins this game in the long run. However, call-option buyers want to take part in the benefits of something that you own, but they won’t put up the cash to buy - the underlying stock. You’re holding the stock anyway, so if you don’t mind offering them some potential upside in exchange, buyers will pay a nice premium for the chance to play the stock without the capital commitment.

This strategy won’t mesh well with every investor’s broader approach. But more importantly, this strategy is not for every stock in a portfolio. You probably do not want to sell all of your potential upside. If a stock is one of your speculative plays, leave all of the possible gains on your own book. Also, if you have to sell the stock at a gain but for less than the strike price before the option expires, buying it back to close the position can be costly. If the stock is up and not much time has passed, the premium on the call will jump. So if XYZ, from the previous example, is the type of stock that you would sell after a quick jump to $54, it might not be right for selling a covered call. The bottom line is if you are looking to gain from short-term volatility, don’t sell away that volatility in the form of a call option. But for your long-term positions that you don’t see going through the roof in the short-term, selling a call is a nice low-risk way to add some income to your portfolio in 2008.

Writing covered call options is by no means the big secret to make millions in 2008. If you’re seeking a lower risk way to dip your feet in the options pool this year then adding this tool might be the way to do it. Find something that works for you. You can boost your premiums by limiting more upside and taking more risk. As for me, I won’t go for any outrageous resolutions this year. I hope that writing a few more covered calls in 2008 will prove to be rewarding enough.

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