Hedge Your Bets

One thing that hasn't been going down in this market is the cost of stock options. High volatility makes options costlier than they usually are. That's a drag if you are in the market to buy. But it's a boon if you're a seller.

Below we outline two popular strategies that involve selling options. You don't have to be a pro to pull off either one, but be sure you understand the basics. To bone up, go to the Options Industry Council's Web site (www.optionseducation.org).

1. Sell a covered call

Selling a call option against a stock you own can generate extra income when you're not expecting much appreciation from the stock. The income will give you some protection if your stock dips in price, but it won't shield you from a sharp fall.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

By selling a call you give the buyer the right to buy your stock at a prearranged price, known as the strike price. You effectively bet that your stock won't rise much during the option's term, which can run up to two years. You're giving up any potential stock gains in return for a cash payment.

Say you own 100 shares of Burlington Northern Santa Fe (symbol BNI), trading in early December at $72. By selling a call expiring in January 2010 with a strike price of $75, you could have earned a $14.40-per-share "premium" at that time. Because of volatility in the stock market, that call price was about $2 more than what a similar option would have sold for in early September. Options are sold in bundles of 100, so your total take would be $1,440, minus commission. (Option prices move with changes in the price of the underlying stock; also, option values fall as the expiration date draws nearer.)

If the railroad's shares don't rise above $75 before the expiration date, your $1,440 proceeds from selling the option, plus possible appreciation of up to $3 a share and dividends worth $1.60 per share, represent a potential annualized return of 23%. But if the stock soars above the strike price, you'll be obligated to sell your stake to the call buyer for what will then be a bargain price of $75.

If your Burlington shares fall below $56 by the time of the option's expiration, the decline will more than cancel out the premium and dividend income. But you'd lose less than you would had you not sold the calls in the first place.

2. Put on a collar

If you're willing to give up some potential gains on a stock you already own in return for limiting your losses, consider establishing a collar. This involves selling a call option (as discussed at left) and using the proceeds to buy a put option, which gives you the right to sell your shares at a prearranged price. A collar effectively locks in a narrow price range for your stock during the option's term for little or no out-of-pocket cost.

For example, in early December you could have taken the $1,440 you earned by selling Burlington Northern calls and used it to offset the $1,320 cost of buying puts with a strike price of $70 and the same January 2010 expiration as the calls you sold. You have now guaranteed that the value of your shares will stay between $70 and $75 until January 2010, plus you can pocket the $120 difference in price between the calls and the puts as well as an additional $160 in dividends.

If the shares are at $75 or above when your options expire, you will have earned an annualized return of 7%. If the shares trade for less than $70 when the options expire, you still have a small, annualized gain of 1%, thanks to the dividend and the leftover proceeds from selling the call.

Thomas Schwab, chief investment officer of Summit Portfolio Advisors, a Denver firm that specializes in collars, says he aims for collars in which the potential gain is two and a half to three times as large as any potential loss. "Look for those situations where people think the stock will go up in the near term and, as a result, the call premium is rich and the put premium is not that expensive," Schwab advises.

Potential gains from a collar strategy are smaller than from selling covered calls, but in exchange you can rest easy knowing you've put a floor beneath your potential losses.