Options trading: some strategies might be risky

NEW YORK - Options trading used to be considered an exotic form of investing that most individual investors left to the pros.

But the price of options drops in a strong market and options have been getting cheaper since 2003. As a result, individuals have become more active in the world of puts and calls.

While volume on broad equity indexes like the Standard & Poor's 500 and the Nasdaq composite has stayed in a narrow band for much of the year, options volume keeps hitting records. July's option trading volume was up by 21.7 percent over last July, according to the Options Industry Council.

As options have boomed, some investors have bought into option strategies and options funds that may not be as safe as they seem. But more on that later.

First, what are options?

Here's a thumbnail sketch of how options work: Broadly, a put gives the buyer a right to sell a specified number of shares at a particular price within a specified time. Put buyers expect the price of the underlying security to fall.

A call gives the buyer a right to purchase a specified number of shares of stock at a fixed price before a specified future date. Call buyers are speculating that the underlying shares will rise.

The holder of the underlying shares who sells options is called the options "writer." The writer gets a fee, called a premium, for writing the option. The premium is based on the stock's most recent close.

There are usually multiple dates and strike prices on the options for most big stocks. There are also options on indexes and exchange traded funds.

So, for instance, if you think Microsoft Corp.'s stock is going to fall, you can buy a three-month put to sell 100 shares at $30 a piece, paying a premium of about $275. If Microsoft falls to $25 a share, you buy shares at the market price, then sell them to the writer for $30 each, pocketing $5 per share, minus your $275 premium, for a nifty profit of $225.

Of course, if Microsoft stock rises to $30 or above within three months, you are, as they say, "out of the money." Your options are worthless and you've lost the $275 it cost to make the bet.

If you're intimidated by options, you're not alone. The Chicago Board Options Exchange runs the Options Institute, whose six full-time instructors usually teach seminars for brokers, and have also run sessions for workers at the Internal Revenue Service and the Federal Reserve.

What's the breakdown of institutional versus individual options investors?

"It's a perennial question," said Jim Binder, a spokesman for the Options Industry Council. "The best we get is anecdotal evidence.... It's probably 50-50, but the institutional side is growing faster."

One relatively new product institutions are selling to individuals goes by the cumbersome name of "the closed-end covered write fund."

The funds, which hold on to their underlying equities but sell options for others to buy them, can make a tidy profit on the premiums they charge to write the option. In many respects, the funds look like a bet that the market will continue to go sideways, trading in a narrow range.

"Closed-end covered write funds have become extremely popular," said Tom Stotts, director of hedging options at RBC Dain Rauscher. Assets under management in such funds are "probably in the billion dollar range," Stotts said.

"Lots of people are consuming them; they may not know exactly what they're consuming," he said.

Like all closed-end funds, the write funds raise their money, then take no new investments from either existing or prospective investors. One fund is the Madison/Claymore Covered Call Fund, which has $284.9 million total managed assets, according to its Web site. Another is the First Trust/Fiduciary Asset Management Covered Call, which has $386 million in assets under management.

Bernie Schaeffer, chairman and CEO of Schaeffer's Investment Research and an expert in options, is skeptical of the strategy the funds employ.

"Because the market hasn't been doing anything, lots of people are selling options, selling calls for the stock they own," Schaeffer said.

That's a risky strategy, he said, and the funds are risky, too. The funds make their income from the premiums, which are shrinking. They're unprotected if their stocks fall. And they've sold away appreciation if their stocks gain.

"Investors are mistakenly looking at these as conservative income funds without the kind of downside risk you would have in a conventional investment," he said.

"While you can sell an option for a dollar and that gives you a bit of a cushion, what good is that going to do you if the market plunges 10, 15 or 20 percent?" he said. "It's not going to cover you at all."

"There's a disconnect between what people are doing and the reason for buying stock in the first place," Schaeffer said. "Why are you risking your money if you're not expecting, potentially, some very attractive appreciation down the road?"