The Hot Strategy to Hike Your Portfolio Payouts

Over the long haul, investing in stocks has brought huge gains to patient investors. But for those looking for additional income, there's a promising strategy that has gained in popularity recently.

Investors have struggled over the past year to find any way possible to preserve capital and avoid losses. Yet while no one wants to lose money, neither do you want to give up potential gains when the stock market rebounds. A strategy involving options, known as the buy-write strategy, gives investors the chance to earn some extra income from their portfolios while also retaining some of the upside if stocks rise.

How the buy-write works
As its name suggests, the buy-write strategy involves two trades. First, you buy shares of whatever stock interests you. Instead of simply owning the stock, however, you also sell a call option, giving someone else the right to buy those same shares from you at some point in the future.

Why would you buy a stock if you immediately decided to sell it to someone else? To answer that question, you need to look more closely at the call-option component of the buy-write strategy.

The option to profit
When you write a call option, whoever buys that option from you pays you a premium. That's money you get to keep, no matter what happens in the future.

When markets are particularly volatile, as they have been lately, the premium that investors are willing to pay you for the option you write can be quite substantial. For example, look at some call option prices for a few widely held stocks:

Stock

Current Share Price

Potential Buy-Write Option

Option Price

Intel (Nasdaq: INTC  )

14.44

January 16

0.36

Apple (Nasdaq: AAPL  )

90.00

January 95

3.35

Johnson & Johnson (NYSE: JNJ  )

58.84

January 60

1.60

Procter & Gamble (NYSE: PG  )

60.18

January 62.50

1.15

Wells Fargo (NYSE: WFC  )

29.36

January 30

2.05

Chevron (NYSE: CVX  )

70.85

January 75

2.35

Merck (NYSE: MRK  )

28.56

January 30

0.88

Source: CBOE.

Obviously, the opportunity to pocket 2-7% or more of the price you pay for a stock appears quite attractive, as it effectively reduces the net amount you have to pay to establish a stock position.

But as with most appealing investment strategies, there's a trade-off. In exchange for the premium you receive for writing the option, you risk having to sell your shares if they go up in price. And although you can choose an option that will give you at least part of the profits if that happens, the amount you receive for the option will go down for every dollar of profits you keep.

For instance, say you had bought Intel stock for its Friday closing price of $14.44. If you had written an option letting someone buy those shares from you for $15, then you'd have received $0.70. On the other hand, if you write a different option with a higher price -- say $16 -- then you'd only have gotten $0.36 per share in exchange for writing the option.

At first glance, you might think writing the first option makes more sense because it pays you more income. But if the stock price rises sharply before the option expires, then the difference is huge -- because you get an extra dollar more from selling the stock if you write the second option than you would from the first.

Why do it?
Obviously, the buy-write works best when:

  • You want to own shares of a stock.
  • You think it will hold its value over time.
  • Even though it's attractive now, you don't think its price will rise too much between now and when the option you write expires.

In a sense, the buy-write gives investors a no-lose scenario: Either you get some extra cash to hold onto shares you already want to own, or you get paid an instant profit in a relatively short period of time.

As long as you're OK missing out on potentially huge gains, the buy-write strategy is a smart idea to consider. It boosts your income in down markets and locks in gains during bull markets. And it's a relatively simple introduction to all the various ways in which options can help you with your portfolio.

See these articles to learn more about:

On Jan. 12, 2009, Fool co-founder David Gardner, Jeff Fischer, and their Motley Fool Pro team will accept new subscribers to their real-money portfolio service. Motley Fool Pro is investing $1 million of the Fool's own money in long and short positions in a range of securities, including common stocks, put and call options, and exchange-traded funds (ETFs). They also incorporate proprietary CAPS "community intelligence" data into their research. To learn more about Motley Fool Pro, and to receive a private invitation to join, simply enter your email address in the box below.

Fool contributor Dan Caplinger finds options fascinating. He doesn't own shares of the companies mentioned in this article. Johnson & Johnson is a Motley Fool Income Investor pick. Intel is a Motley Fool Inside Value recommendation. Apple is a Motley Fool Stock Advisor selection. The Fool owns shares of Intel. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you great options.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 22, 2008, at 9:12 PM, lwbaum wrote:

    This seems basically like selling insurance: pocketing a small fee in exchange for accepting risk, in this case the risk that the stock will decrease in value.

    It should be possible to back-test this using price records over past years, for example by "buying" randomly selected stocks belonging to the S&P500 10 years ago, then "selling" call options at the strike price closest to 110% of the current stock price and at an expiration date closest to 6 months away. Repeat each time the options expire or are "exercised" if the stock price rises. Add the income from selling the options, the interest on the income, dividends, and the capital gains from stock sales. Subtract the commissions paid. See what the stock plus the net income totals after 10 years (or if the stock becomes worthless), and compare the total with the returns from simply buying and holding the stocks (including dividends and interest on the dividends) over that period. My guess is that this is probably not a good strategy since you get all the losses but little of the gains, and the options income seems too little to make up for that; but the back-test should settle the question.

    Banks in Hong Kong, where I live, packaged and sold these kind of investments to depositers increasingly over the last couple of years. They convinced my wife to buy a deal in which she paid for stock (in this case, HSBC), gets income for 2 years (about 0.5%/month), and either gets the money back if the stock goes up above a certain price or else gets the stock. I suppose the bank took her money, bought the stock, sold call options, and returned the income from selling the options (minus a fee) to her in monthly installments. Then, the bank will give her the money back if the options are exercised and will give her the stock (minus dividends?) otherwise. So far, the stock has fallen about 40%, along with the market.

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