V.10:2 (79-80): A Low-Risk, High-Potential Return Option Strategy by Jean-Olivier Fraisse, C.F.A.

A Low-Risk, High-Potential Return Option Strategy 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 simplicity).