Favorite Options Questions, Answered

Fill in the blanks before year-end with six of the most popular topics for reader queries.
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In an attempt to clear the deck and make room for fresh boughs of folly, I present six of the most frequently asked, intriguing and indecipherable questions of 2004. That's one for each remaining trading day of 2004, including this one, so savor these before they're gone.

1. Options and a Retirement Portfolio

Can you discuss the place for options in an ongoing retirement portfolio? I have a portfolio of stocks and bonds that constitute the bulk of my retirement. I wonder at times when I read your column how I might use options to enhance returns or, more importantly, protect against the downside. My most-used strategies now are to hold plenty of cash (at least two years of income) and to be quick to sell when stocks break their 50-day moving averages. -- D.G.

Covered calls are the most obvious way to generate incremental income and gain some downside protection. In this sense, they act to smooth out your returns. A covered-call portfolio's profits will be limited on the upside, but losses should be reduced when the market declines.

The CBOE's BuyWrite index, BXM, tracks the performance of a systematic approach to writing at-the-money calls against the

S&P 500

index. Data on the BXM's returns show an average annual return of 12% over the last decade.

A past column provides some detail on its construction, methodology and returns. Currently, the BXM is up 8.2% for the year to date. Compare this with the S&P 500's approximately 9.0% gain thus far in 2004.

If you are looking to put more emphasis on hedging the risk of your portfolio against a market downturn, I suggest you learn more about

hedging. Schaeffer Research offers a free

portfolio protection analyzer that can help you calculate the cost of hedging a portfolio for various scenarios.

2. The January Effect

In a recent column, you mentioned the January Effect and noted, "This doesn't mean the market will actually rise, only that small-caps will outperform large-caps." If that's the case, then rather than buying calls on the Russell 2000 or specific stocks, wouldn't this argue for some sort of strategy that is long the Russell 2000 and short the S&P 500, thus capturing the differential performance? -- B.

You are absolutely correct. A paired trade might be the best way to capture the statistically probable trade described by the January effect. However, because there are still no options on the

S&P Depositary Receipts

(SPY) - Get Report

, it would require selling calls on the S&P 500 index or options on futures. They each represent nearly 10 times the value of the SPY, meaning the trade would need to be done on a ratio basis.

But also keep in mind that the futures might necessitate a separate commodity trading account. This could be a problem for and unattractive to many readers. Of course, you could pair the trade simply using two exchange-traded funds, buying the

Russell 2000 iShares

(IWM) - Get Report

and selling the SPYs. However, this wouldn't take advantage of the leverage and limited risk offered by using options.

Thank you for the insightful comment and pointing out an alternative (and possibly better) way to take advantage of the January Effect.

3. Open Interest

In regard to open interest when dealing with calls or puts, who decides how many contracts there are outstanding? In some smaller companies, I have noticed only a few contracts -- e.g., 10 -- to be traded, while with Cisco and other large companies, there are several thousand. -- A.Z.

Unlike shares of stock, which are bound by the shares outstanding and the publicly traded float, option open interest is unlimited and bound only by investor activity. The reason the

Cisco

(CSCO) - Get Report

options have much larger volume and open interest is simply because more people want to trade them. Nothing prevents a smaller company's options from trading a large number except demand. You just need two willing parties.

4. Simulated Options Trading

I would like to get involved with options but, with the exception of one options and futures course in college, have only been exposed via some of the columns on

RealMoney

and snippets in Columnist Conversation. Is there any software that simulates actual option action and trading that you would recommend? I'm having a hard time getting my arms around what type of dollar exposure I am putting at risk when trading options. -- E.A.

While real-time experience is always the best teacher, new technology has allowed some good simulations. The online brokerage firm OptionXpress recently added a paper-trading feature to its site. It simulates the way orders get executed in terms of price and time and will tally up your profit/loss on a market-to-market basis. While it is mainly offered to those who have current accounts with the firm, it requires no actual dollar deposit and you can see a free demonstration.

But remember, as I pointed out in my

column on paper trading, simulators can be helpful but they will never truly replicate live action or having real money at risk.

5. Topics for 2005

ha ha, chicken little!!! qqqq's trade at 37.20!!! whats the point of having a vixen!! and an expiration and a CHART!! if crosses like that occur... any professional trading platform reflects the trade... go figure that checking online youd think it never happened....except maybe i didn't hallucinate ...not just some 40 pennies the q's went ex div....and even with the rotating old and new components...we're talking one print 2.40 down at the open...it was real!! lets see a story about that trade being crossed otc.... while i admire it... it shouldn't happen like that if only just to not screw up my charts!!!!or make a chicken little out of you....

This missive, a response to

a recent column, makes the list not just because the reader makes great use of exclamation points and ellipses, but because it covers an incredible amount of terrain. This reader discusses everything from dividends and expiration anomalies, to rules governing crossing of trades, to the psychology of trading and the limits of technical analysis. I hope to address each of these issues in greater depth in the coming year. For now, I will start by making "I refuse to let the market make a Chicken Little out of me" my investment motto for 2005.

6. Options Reading

Have you written any books regarding the A-to-Z's of options trading, or do you have your own Web site or newsletter regarding options and other investments vehicles? -- M.

No, I haven't written a book ... yet. But that gets me thinking: It would've made a great stocking stuffer.

In the meantime, those who don't write can always recommend. Some suggested reading I've mentioned in the past include Larry McMillan's

Options as a Strategic Investment

and Robert Ward's

Options and Option Trading

. A great online resource for anything to do with options is the

Options Industry Council Web site. And for an excellent read on an approach to general investing and trading, I suggest Michael Covel's

Trend Following

.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.

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