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Options on Covered Calls

This column was originally published on RealMoney on Dec. 20 at 11:18 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Roger Nusbaum's recent column on the siren song of options -- and the dangers -- makes some great points, especially about the way unrealistic expectations can lead to being exposed to unanticipated risk. This is especially true when you're using covered call or buy-write programs, which have become increasingly popular strategies for generating incremental income and boosting returns. Buy-writes are also touted as a way to reduce risk and lower the volatility of a holding or an overall portfolio.

But one of the biggest mistakes, as in most trading approaches, is not sticking with the defined strategy. That is, investors tend to roll up or not sell calls at all on stocks that are rising for fear of capping gains, or they roll down or sell a greater number of calls or even buy puts to protect stocks whose price is declining.

One way to avoid letting emotions wreck what can be a very effective strategy is to use a proven approach, or let a professional run the buy-write portion of your portfolio. The proliferation of mutual funds and exchange-traded funds that use option-selling techniques makes it possible for individuals to pursue both goals more easily, and makes accessible a variety of approaches on buy-writes that can align with your goals.

The CBOE's BuyWrite Index (BXM) uses a mechanical approach. It creates a covered call in the S&P 500 by selling 30-day, at-the-money call options on a one-to-one basis and being long the index. There is now an estimated $900 billion benchmarked to the BXM, and variations on the theme -- with varying degrees of success -- keep multiplying.

The BXM is 12.5% for the year to date (2006), and hit an all-time record on Monday. Those are pretty impressive returns on several fronts, being about two percentage points below the S&P 500 index. That's certainly significant, but is still an impressive performance given that the S&P has done nothing but go straight up while the implied volatility of its options remains historically low, offering little in the way of premium income.

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