Accomplish Two Goals Using One Strategy

September 16, 2008
Mark D.Wolfinger

Physician's Money Digest, February15 2003, Volume 10, Issue 3

By now, you're probably well aware of theimportance of following your dreams. Andas a child, you probably dreamed aboutbecoming a doctor when you grew up. But nowthat you're an adult and have realized this goal,what do you dream about as a physician-investor(other than being generously rewardedby the stock market)?

One dream many investors sharetoday is achieving a desired rate ofgrowth while gaining portfolio insurance.This may not sound as much funas the road you traveled to become adoctor, but being able to turn thisdream into a reality can provide similarrewards. But how is a busy physician-investor to achieve this financialdream? One way is by taking advantageof call options.

CALLING ALL INVESTORS

Over the years, stocks have grown,on average, at a compounded annualrate of 10% to 11%. And over the years,as you may know firsthand, some stockshave managed to bottom out. Since thisis the nature of the market, it makesgood sense that investors desire profit and protection.Fortunately, call options can help physician-investorsachieve a higher rate of return while protectingthem against declining stock prices.

To illustrate how call options can help achievethese results, consider the following example. Let'ssay that you own 100 shares of XYZ, which is tradingfor $40 per share. Now, let's assume that you sella call option that expires in 6 months. This optiongrants the option buyer the right to purchase yourstock for $40 per share. In return for selling thatoption, you then receive a premium of 6 (ie, $6 pershare). Since the option represents 100 shares ofstock, you will receive $600 for the call option.

Altogether, you have $4000 invested in XYZstock (the current stock price is $40 andyou have 100 shares). Selling the calloption reduces your net investmentfrom $4000 to $3400 (the cost of theoption sale is $600). In addition, youwill have to pay your broker a commissionfee, which is purposely ignoredhere for simplification.

Even though you bought XYZ stockplanning to hold it for future growth,you may be obligated to sell it for $40when the option expires (eg, if theoption owner chooses to buy yourstock). If this happens, you will have aprofit of $600 on an investment of$3400. What this means for you is areturn of 17.6% in 6 months. On anannualized basis, that is more than35%, and considerably more than yourdesired return. However, you may notwant to sell your stock, which can actuallybe avoided. But if you earn over 17% in 6months, you'll probably feel you're receiving adequateconsolation for selling the stock.

POTENTIAL FOR PROFIT

Just like almost every investment strategy availabletoday, there are both advantages and disadvantagesto selling call options. Unfortunately, theprofit you can earn from each of your positions islimited when you sell call options. However, thereis an increased chance of earning a profit whenyou do sell. So you will earn a profit more often,but the profit you do earn will not provide youwith the money to relocate to Tahiti.

If you adopt this method, it's important to realizethat the profit potential for any position in yourportfolio is dependent on the premium (ie, price ofthe option) you receive when you sell the calloption. (If you remember, in the earlier XYZexample the premium was $6.) That premiumdepends on many factors and is different for eachstock in your portfolio. For example, options withmore time remaining until they expire are pricedhigher than options with less time remaining.

In addition, call options of highly volatile stocksare priced much higher than options of less volatilestocks. So if you're one of the more daring physician-investors and own your share of volatilestocks, you'll have the opportunity to make moremoney when selling call options. Of course, whenit comes to investing, for every up, there seems tobe a down. In this case, as you probably knowalready, volatile stocks are more dangerous to ownand provide you with the opportunity to lose moremoney when stocks decline in price.

Unlike many other investment strategies,when it comes to call options, volatility is one ofthe many factors you can use when decidingwhich stocks to buy. So continue to choosestocks as you normally do, but take volatility intoconsideration. It some cases, it can help youchoose between 2 similar investments. If youthink call options may be a good option for you,there are plenty of sources on the market todaythat can provide you with more information.

Mark D. Wolfinger,

author of The Short

Book on Options: A Conservative

Strategy for the

Buy and Hold Investor, is

an educator of public

investors. He was a professional

options trader

at the Chicago Board

Options Exchange for

over 20 years. He welcomes

questions or

comments at mark@mdwoptions.com. For

more information visit

www.mdwoptions.com.