An Options Strategy for Finding Profits in the Tech Slump

Selling covered calls on Internet and biotech HOLDRs can yield a good return with reasonable risk.
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Ah! January. A simpler, happier time when the average investor could have logged on to

E*Trade

, let his new kitten walk on the keyboard and end up with a handful of winners like

Ariba

(ARBA)

or

Protein Design Labs

(PDLI) - Get Report

.

While that kind of easy money seems far away these days, there's an options strategy -- relatively simple, if not quite prom-queen perfect -- that can put investors in a position to squeeze a little more juice out of this market, especially in some of the more tumultuous sectors.

CIBC Oppenheimer

options strategist Michael Schwartz suggests that qualified investors can buy

Merrill Lynch HOLDRs

focused on the biotech and Internet sectors, sell calls against them without incurring too much risk and walk away with some worthwhile profits.

HOLDRs, you remember, are sector-focused baskets of 20 stocks that trade on the

American Stock Exchange

. (See this

Dear Dagen for more on HOLDRs.) Call writing is simply selling a call option contract in return for a payment, called a "premium." The contract obligates you to sell a stock (or in this case, HOLDRs) at an agreed-upon price.

Covered-call writing is a variation in which the seller of the call option buys the underlying stock and keeps it on hand just in case the option to buy the stock is exercised.

Unfortunately, covered-call writing strategies are often too much buck for the bang. To establish and unwind these positions, you often have to do four transactions, generating hefty commissions. And the strategy can unnecessarily cap the upside potential of the stock position.

The recent demolition in

Nasdaq

stocks, however, has created an opportune situation for call writers, especially those who want to dabble in HOLDRs. The reason is that implied volatility, a major component of an option's price, is very high on Internet and biotech stocks. That makes them more expensive -- a good thing for investors willing to risk writing calls.

A Downside Cushion

Biotech HOLDRs

(BBH) - Get Report

fell to 148 this week from 244 in early March. That's the kind of volatility that makes options expensive. Some investors mistakenly view call writing as downside protection; it's not. Yet, Schwartz says, premiums are so high on at-the-money options (those with strike prices at or very close to the stock's market value) that they can give more cover for a long position because the higher the premium, the lower the stock can fall while letting you break even.

For instance, with the Biotech HOLDRs at 148 on Wednesday, its July 150 calls were trading for 26 3/4 ($2,675). Buying 100 Biotech HOLDRs (the minimum purchase allowed) cost $14,800. Selling one of those calls brought in almost 20% of the purchase price. If the option does get called away on the third Friday of July, its expiration date, you would sell the Biotech HOLDRs for a two-point gain on top of the premium you took in for the call.

If the Biotech HOLDRs continue to get battered, you have a $2,675 cushion from the options premium before your covered HOLDRs position falls below break-even.

For the

Internet HOLDRs

(HHH)

, the just

out-of-the-money August 135 calls were trading at 20 3/4 ($2,075) this week with the HOLDRs at 128. The investor takes in more than 15% for the options sale, and in this case, can make up to 7 points on each of the HOLDRs if the market for Net stocks is resurrected before the end of the summer.

Schwartz says that this strategy, like all covered call writing, provides limited downside protection and some upside participation. Of course, the upside could be even more limited if the option is called away before expiration, but Schwartz says he's not particularly worried about that.

"It's almost always better to be exercised. Some of the best sell decisions I've ever made were made for me by the markets," he says, adding that investors often know when to buy but are clueless about when to sell. Plus, he says, wiser call buyers are more likely to sell the contract for a huge gain than take on the stock ownership if the call you sold is trading at a large premium.

The key these days, however, is not to worry so much about the upside you may lose, but to focus on a neutral way to play the current volatility without opening up your portfolio to unlimited risk, such as an out-and-out short or long position. With options premiums so high, especially in the go-go sectors of 1999 and early this year, there is almost the ability to choose the return you want by selling calls that are in, at, or out of the money.

The risk that's prevalent in all call writing is that the Nasdaq rallies and the Biotech HOLDRs July 150 calls, for instance, get exercised early as the HOLDRs run to, say, 200. The current Nasdaq doldrums, though, provide a scenario where that doesn't seem likely to happen, at least for next week.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.