The Handy Tool That Protects Your Portfolio

Often with investing, you'll run across strategies that most people use for one purpose. Yet like medicines that turn out to have more than one beneficial use, some financial tools can play multiple roles in your portfolio.

One example of a multifaceted investment is the option. Commonly seen as a tool for speculators and other high-risk investors, options allow you to trade stocks with far greater leverage than you could obtain simply from buying and selling shares.

One strategy involving options, though, gets a lot of attention from those looking for extra income from their stocks. The covered-call strategy can help you earn more from your investments. Yet in addition to enhancing your payout, covered calls can also help lessen the blow from market downturns.

Using calls as protection
Typically, most investors don't think of call options as providing any downside protection. Buying put options lets you limit your losses, but most call options don't give you any guarantees against downward stock moves.

If you pick the right call option, however, you actually can get some portfolio protection. You just have to pick the right strike price -- the agreed-upon price to be paid for the underlying stock if the option is exercised.

A bird in hand, or two in the bush?
If you think your stock will rise and want to retain some of the upside, then writing calls with strike prices above the current share price makes sense. If you choose lower strike prices, though, you'll give up most or all of the upside -- but you'll get more compensation upfront for doing so.

For instance, take a look at some stocks where using a covered-call strategy might be appropriate:

Company

Current Price

Amazon.com (Nasdaq: AMZN  )

51.92

Intel (Nasdaq: INTC  )

13.79

Apple (Nasdaq: AAPL  )

88.66

ExxonMobil (NYSE: XOM  )

76.54

Wal-Mart (NYSE: WMT  )

51.39

General Electric (NYSE: GE  )

15.83

Wells Fargo (NYSE: WFC  )

23.80

Source: Yahoo Finance. As of Jan. 12 close.

Now compare two different covered calls on each of these stocks, one slightly above the market, the other slightly below:

High-Strike Call Option

Current Option Price

Low-Strike Call Option

Current Option Price

Difference

Amazon July 60

6.70

Amazon July 50

11.95

5.25

Intel July 16

1.05

Intel July 13

2.32

1.27

Apple July 95

11.51

Apple July 85

16.45

4.94

ExxonMobil July 80

7.20

ExxonMobil July 70

12.56

5.36

Wal-Mart June 60

1.68

Wal-Mart June 50

5.70

4.02

GE June 20

0.83

GE June 15

3.00

2.17

Wells Fargo July 27

3.80

Wells Fargo July 23

6.40

2.60

Source: Prophet.net. As of Jan. 12 close.

Notice that in each case, you get significantly more in option premium from writing the low-strike call. That money is yours to keep no matter what happens to the stock. The trade-off is that if the stock rises and both calls get exercised, the low-strike option pays you less -- $50 per share rather than $60 in the Amazon case above.

What if the stock price stays the same? In the high-strike strategy, the option would expire worthless, and you would just keep the premium. For the low-strike strategy, however, the option would still have value. In each of these examples, however, you could buy it back at expiration and still have a profit over the high-strike strategy.

Meanwhile, if the stock falls, neither strategy will involve an option getting exercised. The extra premium will have helped you reduce your losses from the stock.

Does it make sense?
Of course, if you're willing to give up all the upside, why not just sell the stock? There are several possibilities. Capital gains taxes can play a role. High volatility levels give you more money from writing options. Or if you think a stock's upside will be suppressed only temporarily, you can pick your option expiration date to coincide with whatever catalyst you believe will make the stock move upward.

This low-strike covered-call strategy is just one example of how commonly used investing tools can serve many different purposes. Keep your mind open to potential multiple uses for such tools, and you'll enhance your investing technique and be able to capitalize on opportunities others miss out on.

For more on successful investing strategies, read about:

In the new Motley Fool Pro real-money investment service, we're teaching about and using covered-call strategies. We're also building a long-term stock portfolio and using other option strategies for income and better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.

Fool contributor Dan Caplinger loves finding new ways to use old tools. He owns shares of GE. Wal-Mart and Intel are Motley Fool Inside Value selections. Amazon.com and Apple are Motley Fool Stock Advisor recommendations. The Fool owns shares and covered calls of Intel. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps you covered.


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