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Sunday, August 07, 2005

Some Options Strategies are Not As They Seem (from Forbes)

A call option gives the holder of the option the right (but not the obligation) to purchase the underlying stock at a given price within a given time period. The price the holder pays for this right is called the call "premium". People who sell (or "write") calls do so to collect the premium.

The last few years, interest rates have been relatively low by historical standards. At the same time, the stock market hasn't exactly overwhelmed either. So, in an attempt to gain more income , some investors have taken to writing call options (to collect the premiums).

Forbes has an article titled "Some Options Strategies Are Not As They Seem" which gives a good and relatively low-tech discussion of this practice. Here's what's probably the best quote in the article:

"...There's a disconnect between what people are doing and the reason for
buying stock in the first place," Schaeffer said. "Why are you risking your
money if you're not expecting, potentially, some very attractive appreciation
down the road?"

For the full piece, click here.

Once again, let's review what the principle of Efficient Markets would say -- thatprices and returns of publicly traded investments are "fair". In other words, they accurately reflect the risk of the investment. So, there's no such thing as a free lunch. If an investment strategy looks like a way to make more return without taking on more risk (or without giving up something else in return), you're missing something.

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