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An Options Play for the Faint of Heart

By Robert Barker Even experienced stock investors can freak out at the prospect of trading options. Not only is the options market wickedly complex, but it also has its own lingo and, if approached naively, can be extremely risky. But for every option that's traded, there are both risk-courting and risk-averting sides of the deal. Now, a new mutual fund has popped up to offer investors a way to tackle the risk-averse side of the options market.

It's called the Buy-Write Fund. With assets of about $3 million, it's still too small to have a functioning ticker symbol (its identifying "CUSIP" number is 75418R108). It operates by simultaneously buying big, liquid stocks, such as Schering-Plough (SGP), and "writing," or selling, call options on the stock. The fund pockets the premium income paid by the buyer of the option. The downside is that, if the stock goes up, then the fund misses out on some or most of the upside.

Because the fund began operating in February, it has no real track record. Private accounts run the same way by the same managers returned an annual average of 12.5% from their February, 1996, inception through June 30, 2000, vs. 22.6% for the Standard & Poor's 500-stock index. In the year ended last June 30, these accounts returned an average of 14.4%, about double the S&P 500's 7.22% return.

Curious about this new fund, I reached its sponsor, Glen Rauch of Glen Rauch Securities, the other day by phone at his Manhattan office. You can learn more about the Buy-Write Fund by looking over the prospectus or by reading on. What follows are edited excerpts of our chat:

Q: What's this new mutual fund of yours all about?

A: For about the past five years, with a lot of my individual accounts, I have employed a "buy-write" strategy.

Q: Which is what?

A: You buy the stock and you "write," or sell, the call [option to buy the stock]. You take in the premium [income from the sale of the option]. So what I've done for an economy of scale is roll all my individual [accounts] into a mutual fund.

Q: I see.

A: Instead of buying, let's say, 1,000 shares of Pfizer (PFE) and charging $300 commission for each account, now I buy 10,000 or 25,000 shares and do the trades for [a] $30 [fee]. And the returns have been exceptional -- significantly outperforming the S&P and other indexes.

Q: All right. What's the expense ratio, and is there a load?

A: It's a no-load [fund], and I've capped the expenses at 1% [far below the nominal expense ratio of 3.85%].

Q: What kind of returns did your individual clients see? And isn't this risky?

A: The worst-case scenario [was] a 6% return, and I've had some people who have as much as a 60% return, because I use different stocks at different times. We only use those stocks that are highly rated by S&P, and we use Bloomberg research along with Morningstar and Value Line. We only use large-cap, very liquid stocks. We never buy anything two or three weeks before earnings are released. We don't like any surprises. I have a very strict discipline that if the stock drops 10%, I just sell it.

Q: I see.

A: So that hedges it on the downside. And basically, I use a universe of between 20 and 25 stocks.

Q: Why don't you walk me through an example of one stock?

A: Well, the easiest thing is the one I just did this week. I bought 1,000 shares of the Nasdaq 100 Trust, the QQQ

. I bought it on June 5, and I bought 1,000 shares at $46.75. I sold the "July 48" [call option]. In other words, the option that expires the third week in July. For that they paid me a premium of $2.85.

Q: That's $2.85 times 1,000 shares, right?

A: Correct. So I bought it at $46.75. I took in $2.85.... I've made a return of 5.87%. Which, if annualized, would be a return of 46.52%.

Q: I see. And then you say you have a fixed rule: If the shares fall 10%, then you just liquidate the position?

A: Correct. And that protects me, because if I make, let's say, 3% or 4% or 5% from the option [premium] that I received, then the loss is really only 5% [or so]. So it's very closely monitored, and the downside I keep minimal.

Q: Now, is this a strategy that works best in flat markets, rising markets, or down markets?

A: Flat and sideways work the best. Because ideally, what you want to do is keep riding the option -- keep rolling over and taking in the premium. If the stocks are in a very bull market and they keep running away, you're always going to get called away. You still make money, but you're not maximizing your return. And it's not that it's such a defensive move in a down market, because in a down market you don't want the stocks to keep dropping, either.

Q: Gotcha. When you get the income from having written the option, is that ordinary income that's taxed at ordinary income-tax rates?

A: It's ordinary income, exactly. And then when the stock gets called away, it's a short-term capital gain.

Q: So this works best in a tax-protected account.

A: It's really not a tax-efficient type of trading.

Q: What's the worst thing that you've seen happen to somebody employing this strategy?

A: I've got cases where I owned the stock at $30 and -- let's say I wrote a call for $32 -- and someone comes in and takes the company over at $50. That's kind of like the worst-case scenario, because you still made money but the company got taken over. That's really the worst thing that can happen. Not that it's a bad thing, it's just that you didn't maximize the return. But that's not why you employ the strategy.

Q: I gather that you also like to pick up the dividend on such stocks as Philip Morris (MO). What are some other stocks that you like to use?

A: Well, let's see, just this week I've done Cisco (CSCO), I've done Philip Morris, America Online (AOL), and JP Morgan Chase (JPM). And I also did AT&T (T).

Q: What else about the fund does an individual investor need to know?

A: It's a $2,000 minimum initial investment. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His column appears every Friday, only on BW Online

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