A Low-Risk, High-Potential Return Option
by Jean-Olivier Fraisse, C.F.A.
Can call options be used as a substitute for purchasing stocks? Covered calls — selling a call on stock
being held — is one low-risk strategy, but profits can be limited on an up move. Another low-risk
strategy, the long call plus cash equivalent, attempts to preserve capital while combining safety and
potentially high profit. Jean-Olivier Fraisse explains how.
Options trading is not for the faint of heart. Beyond technical skills, it requires intuition and just plain
luck. Some option strategies, however, are no riskier than stock ownership. A well-known low-risk
strategy is covered call writing, which consists of selling a call on stock currently held. It works well in
stable or declining markets, but it limits profits on an up move, which can be costly in the long run. A
second low-risk strategy, the long call plus cash equivalent, strives to preserve capital while combining
the safety of a fixed-interest income and the potentially high rewards of stock ownership. This low-risk
strategy is most attractive when interest rates are relatively high. It does not work as well when short-term
rates are low, as was the case at yearend 1991. It is up to the reader to decide whether the strategy
remains attractive for his or her own circumstances.
STRATEGY: BUY CALL, INVEST CASH
The market outlook appears bullish and you are of the opinion that stock XYZ is currently undervalued at
a price of $100 per share. In your view, XYZ should trade at a higher price with good prospects for a
significant move in the near future. You are considering the purchase of one hundred shares of XYZ stock
for an investment of $10,000 plus commissions (commissions are ignored from here on for the sake of