Option Income Funds - Big Returns But Big Risks

The latest Wall Street high-income investment is the option income fund. Born from the income investor's need to generate ample and reliable income, Wall Street brokerage firms have come up with option income funds, which are closed-end funds that buy stocks and then write options on them to pocket the option premium. These sometime named covered call funds offer a rich yield from 8% to 10% as of June 2005.

Five newly minted funds in 2005 include: S&P Covered Call Fund (BEP), NFJ Dividend, Interest & Premium Strategy Fund (NFJ), Madison Strategic Sector Fund (MSP), Dow 30 Premium & Dividend Fund (DPD) and Advent/Claymore Enhanced Growth & Income Fund (LCM). All have yields greater than 8%.

But with these attractive returns comes risk. Covered call funds work best when stock prices remain flat so covered calls can be sold repeatedly without the underlying stock being called away. Therefore, if stock prices begin to rise, many of a fund's holdings will be called away (sold at predetermined prices) so investors will loose out on the stock price appreciation. Under rising stock prices option income funds may lag growth and growth and income funds. If stock prices fall, future option premiums and payouts to investors will be reduced. And the price of a fund may slip.

Do not purchase any closed-end fund at its initial public offering price because hefty fees are built into the IPO fund price. So wait a few months until the fund's price settles down and its payout rate is established.