Dollars & Sense December 14, 2001

Go Back to Archives	"Dollars & Sense" By Tom Haugh - Chief Investment Officer

Paid to Get Out? December 14, 2001

We have been discussing recently the inherent and possibly increasing risk associated with holding non-diversified and non-hedged positions in individual stocks, known in the trade as "concentration issues". In addition we have discussed the idea of having target prices, or identifying a price at which we would no longer want to own a particular stock. Both of these previous discussions are contained in the archives.

One method used by investors to identify an upside price target is the sale of a covered call option at a strike price at or above the investors price target. Using the example of an investor who feels a particular stock is undervalued at $37, but thinks that the stock would be fully valued at $50 in six months, he or she may look to sell a call at the $50 strike six months out. Clearly there are risks inherent with this strategy, but for an individual who is already comfortable with the risk of stock ownership at $37 it is a way to formalize and, in fact, get paid for identifying an upside price target. The advantages are the following:

Having the action already in place, meaning that if the stock is over $50 at expiration, insures that the stock will be sold for you at $50 as part of the expiration process. This "relieves" the investor of the responsibility of actually making the call to the broker to sell his beloved stock. At PTI Securities many investors who were saved the worst effects of this years brutal sell-off did so because some of the stocks they were long, including Enron, were sold as part of the expiration process in the first quarter of the year. From a broker's point of view, it is easier to remind the client that the upper price target was their own rational assessment, rather than hoping the client will call out of the blue to sell a stock that has been profitable. That rarely happens.
The sale of the call option at your target price provides income. How much is dependant on many variables unique to the particular stock and market conditions at the time, but continual sales over time could tend to add up nicely.
Whatever income provided by the sale of the call option reduces the risk of holding the underlying security. It may not be much, but if the call is sold at $2 and the stock price is $37, the risk in the total position is reduced to $35, which is also the break even for the position.

The most important of these, at least initially, is the formalization of the upside price target. It also leaves the flexibility of changing the price target if the need and desire are there. Over time the income could build to where it also becomes a reason unto itself. Any option strategy needs to be reviewed as to risk and the Option Disclosure Document reviewed thoroughly.

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