By JEFF D. OPDYKE 

ICTOR SCHILLER is generating steady in­come off a stock portfolio ravaged by the bear market

     His trick: Writing covered-call options contracts.

     Options-which give investors the right to buy or sell stocks at a certain price by a specific date-are generally thought of as complex tools for the pros. But covered-call options are regularly used by individual investors and are much less risky than more exotic option strategies, which can subject you to huge losses. Covered calls work best in a sour market, not unlike today’s.

     In Mr. Schiller’s case, the Culpeper, Va., investor sells contracts that give other investors the right to purchase his shares at a set price. In return, Mr. Schiller is paid anywhere between 20 cents and a couple of dollars a share. If the stock goes down, Mr. Schiller keeps the payment. If it goes up sharply-something that hasn’t happened much this year-he makes less profit on the stock than he would have if he hadn’t sold the calls.

     Covered calls have been around for years, but they’re gaining popularity amid a down market. At OptionsXpress, the largest online options-trading firm, 37% of customers are using a covered call strategy these days, up from 12% a year ago. Big financial institutions like J.P. Morgan Chase and Merrill Lynch also report a surge in covered calls from both institutional and individual investors. “Since the market decline in 2000, [this technique] has become much more popular,” says Heiko Ebens, derivatives strategist at Merrill Lynch.

The increased popularity of covered calls underscores how the bear market has transformed options trading. During the tech boom, investors often traded options instead of actual shares-gaining control of more shares for the same dollars-to supercharge their profits as stocks surged. Nowadays, many of the speculators are gone, and investors are using options to generate income, protect their portfolio and lower the volatility of the stocks they do own.

You can trade options either through brokers or online. Commissions can be as low as $15 a trade at discount brokers.

Here’s how covered calls work: Suppose you own 500 shares of Wal-Mart Stores stock, recently in the $50 range. You can sell December contracts that give other investors the right to buy the 500 shares from you at $55 a share on or before Dec. 20. Those contracts were recently selling for $1.70 per share, meaning your 500 shares would have brought in an $850 premium.

 Come Dec. 20, one of two out­comes unfolds. If the stock remains below $55, the options contracts expire worthless, since the buyer who owns them has no interest in paying $55 for stock that is worth less. So, you keep the $850 and you keep the stock.  

     If Wal-Mart shares move to, say, $60 a share, the options buy­ers will exercise their rights to buy the stock at $55 a share. You probably lose the stock, but you keep the $850 from writing the contracts as well as $2,500 in profits from the stock’s $5-per-share move to $55 from $50.

     “You’re basically owning a stock and generating a return

that can be greater than bond yields,” says Steven Silverman, senior vice presi­dent at Connors Investor Services, a money-management firm specializing in covered-call-options investing in Wyomissing, Pa. Some of the firms’ clients, Mr. Silverman notes, “are living off the options income we generate every month in their account. It’s a very attractive alternative in a low­interest-rate environment.”

     Of course, there’s a big downside to covered calls. By selling a Wal-Mart call, you risk having to sell the shares if the option is exercised, thereby triggering a tax hit. Even more important, you limit your potential upside. If Wal-Mart moves to, say, $70, you still must sell at $55, forsaking much larger profits.

     What’s more, writing covered calls isn’t a hedge against a stock tanking. Carmelo Montalbano, a Washington, D.C., investor who has been writing such calls for years, last month bought shares of power company Calpine. At the same time he sold calls. But the stock collapsed. He got to keep the premium from selling the calls, but the share-price loss erased that gain. Now he’s holding a stock priced about $2.11 a share, too low to bother selling calls.

     Not everyone is a fan of writing covered calls. “The problem is you take away your upside and you don’t protect

your downside,” says Ross Levin, a financial planner in Minneapolis. Even proponents of the options say they aren’t for every market and every stock. Volatile stocks tend to bring in the highest premiums. But there’s a greater chance their shares will move substantially higher, and most of the profits will go to the options buyer.

     Blue-chip stocks tend to be a good bet, says broker Mitchell Kurtz of Advest, who generates half of his business writ­ing covered calls for clients. The premiums tend to be smaller, but there is less chance the options will be exercised, triggering a sale of the underlying shares.

Investors probably shouldn’t write calls on any position fewer than 500 shares, otherwise the premiums earned generally aren’t worth enough to offset the costs involved.

     Trading covered calls makes the most sense inside tax-advantaged accounts such as an IRA or a 401(k) that offers a brokerage link. There are two reasons. You defer taxes on premiums and profits. And you generate more investable cash in tax-deferred retirement accounts, which limit annual contributions.

Still, some investors use covered calls to generate spending money. Glen Navis, an investor in West Los Angeles, Calif., says he buys stock and sells calls on his stock purchases continually, generating cash to pay some of his family’s living expenses. “It’s just an easy way to earn a high return,” says Mr. Navis, who recently bought 400 shares of Pepsi Bottllng Group at $24 and sold four October 25 calls. He netted $305, or a return of about 5% for a month and a half.