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By Jason Stipp | 01-26-2011 02:19 PM

Two Option Strategies for Retirees

Morningstar derivatives strategist Phil Guziec outlines one option-investing strategy for income-seekers, and one for the risk averse.

Jason Stipp: I'm Jason Stipp from Morningstar.

It's Retirement Portfolio Week on Morningstar.com, and today we're talking about strategies outside the typical stock/bond allocations in a portfolio.

I'm joined today by Phil Guziec. He's a derivatives strategist and editor of Morningstar OptionInvestor newsletter. He's going to talk about two option strategies that retirees may want to consider.

Thanks for joining me, Phil.

Phil Guziec: Thanks for having me, Jason.

Stipp: So, a couple of strategies. The first one is an income-oriented strategy. It's something that could boost the income from your portfolio. This is an issue a lot of investors are looking for ways to get a little bit of extra income in today's environment. Can you explain a little bit about how that works?

Guziec: Well, the classic income-generation strategy using options is a covered call, which is actually the same transaction as the cash-secured put. In a covered call, basically, you sell the upside on a stock above the given price in exchange for a little extra income. So, you're kind of pulling ahead potential returns you might have in the future or giving up upside opportunity for cash today.

Stipp: So, can you explain in practice ... can you give me an example of how that might work and how that selling of the upside, what does that actually mean with an example?

Guziec: Well, let's say you have a company that you think the downside is relatively limited. You can also do this with stocks that you own that have already run up, and you're willing to give up upside above a certain price, but the best is if the downside is limited. And let's say that stock is trading for $20. You can buy the stock and then sell the call option at $21 or $20 or $22. The further out of the money, the higher the strike price you sell the option, the less income you get.

In exchange, you get some cash. If the price of the stock is above that strike price at expiration, someone will call the stock away from you. If not, you just get to keep the cash and you keep the stock.

Stipp: So not a bad deal in the meantime for you. Are there any disadvantages? What should be on investors' radars as potential downsides or risks to using the strategy?

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