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The idea of selling a call option while simultaneously owning the underlying stock (known as a covered call) often attracts the savvy investor. Covered call investors (or writers, in market parlance) ride the same roller coaster as uncovered stock investors. Covered call writers, though, receive cash up front in exchange for capping some or all of their potential future gains from the stock.

A covered call thus changes a stock owner's investment returns in one of three ways. If the stock's price falls, a covered call falls less. If the stock price stays unchanged, the covered call leaves extra cash in the writer's pocket. And, if the stock price rises, the covered call participates in the rise up to the strike price selected by the option seller.

You have to answer two questions before you decide on the prudence of writing covered calls: Do you expect the price of the stock being covered to go up or down? Do you think the call option is worth selling? If you have already decided that you are willing to ride with the broad market by holding a diversified group of stocks, then the only decision that remains is finding those call options worth selling against some or all of the stocks in your portfolio.

In selecting which call options to sell, professional traders look for options that have the most value, or what we like to call "juice." While it might be tempting to just look for those call options that are the most expensive (and thus may be the best candidates to sell), the price of an option can be a poor measure of its juice. One option can have a higher price than another simply by having a longer time until expiration, or by being deeper in the money. Both of these conditions expose you to greater risk, and that is why those options have a greater price in the market but not necessarily more value to you as a short position.

A popular measure of an option's juice is what traders call its implied volatility, which accounts for all the factors that can affect an option's price. The higher an option's implied volatility relative to how volatile you think the stock will be, the better candidate that option is for selling against your portfolio.

Where can you find the options with the highest implied volatilities? Generally, there is a pecking order to implied volatilities in the stock market, and this pecking order can be exploited. The options with the lowest implied volatilities are those on broad market indices, such as the

S&P 500

or the

S&P 100

. Next in line are the more narrowly based sector options, such as the banking, technology or drug sector options. Another portion would be the options on individual blue-chip stocks such as


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General Motors

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. The most juice can be found in the options on aggressive go-go stocks such as those in the technology or biotech sectors. The table below illustrates this pecking order using a snapshot of actual one-month at-the-money options taken in the past few trading sessions. (Note that the option prices have been adjusted to be pennies on an equivalent dollar spent.)

Obviously, the best game plan seems to be to sell a wide array of individual equity call options on those stocks held in a broadly diversified portfolio. This would clearly provide more juice than selling an equivalent amount of broad index options on the same portfolio, and with no greater limitation on the upside potential of the stock portfolio (assuming the strike prices were all chosen comparably).

But is this a viable strategy for the individual investor? Probably not. An individual investor would most likely get eaten alive by the commissions generated on all those separate options trades. Also, when writing call options on numerous individual equities in a portfolio, a far greater degree of attention must be paid to the portfolio. As options expire at differing times, they must be rolled to longer maturities, and those options that expire in the money will force the investor to deliver that stock to the call buyer, necessitating replacement of that stock in the portfolio.

So how can the average Joe take advantage of the higher juice in individual equity call options without being exposed to just a few stocks? Generally this is a technique available only to professional money managers who have the clout to keep commissions low and to deal with the all the monitoring hassles of a portfolio that uses numerous options. One alternative is a mutual fund, but the selection of those that use options is slim.

Our fund, the

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Analytic Defensive Equity fund, essentially takes two bets: The first is at the stock portfolio level, where the manager uses a quantitative stock selection program to select the 70 to 100 stocks he likes best from within the S&P 500.

At the second stage, the manager sells call options against this portfolio, using a mix of individual equity, narrow sector and broad index options. In addition, since there is a mind-boggling array of options to choose from (once you take into account all the strike price and expiration date choices), the manager uses an option selection methodology that helps find the best options relative to mathematically generated forecasts of future market volatility.

Bannon is a managing director at Analytic Investors. At the time of publication, neither he nor the company's funds held positions in the equities mentioned here.