The S&P 500 has jumped more in the past five months -- about 50% -- than at any time since 1938, toward the end of the Great Depression. However, if you take a gander at the years following 1938, you see -- after that big market rebound -- that stocks were relatively flat for a handful of years, including about 10% declines in both 1940 and 1941.
If you were an investor back then, you were left twiddling your thumbs, merely hoping for additional gains from the market at some point. These days, we're more fortunate. The market may end up being flat for a few years after its recent jump, but stock options, launched in the 1970s, give even a conservative investor ways to profit when a stock is flat.
The benefits of covered calls
The most common option strategy to profit if a stock stays flat, or goes down modestly, is also the most conservative: covered calls. When you write covered calls, you're selling an option contract that simply says: "I own at least 100 shares of this underlying stock. If the stock increases to my option's strike price by the option's expiration date, I'll sell you my shares at the option's strike price." In exchange for the contract, you get paid an option premium up front, and you keep that payment. This makes covered calls a popular income strategy. The risk is also modest.
For example, assume you own 500 shares of Intel (Nasdaq: INTC ) , recently $18.50, which you'd be willing to sell if the stock hit $20 by January 2010. You could write five call option contracts (each one represents 100 shares of the underlying stock) with a strike price of $20, expiring January 16. Those options would recently pay you $1.05 per share, or a total of just more than $500. That money is delivered immediately to your account, and is yours to keep.
Let's see what might happen.
If Intel doesn't reach $20 before mid-January, you keep your shares -- and you still keep the option income you were paid. This equates to earning an additional 5.7% yield ($1.05 divided by $18.50) on your stock in just five months. And you can then write new covered calls for more income, if you like.
Conversely, if Intel is above $20 by the expiration date, your shares are "called" away, sold from your account in January as the options are exercised. You're paid $20 per share for your Intel, and you still keep what the options originally paid you, so your net sell price is actually above $21. You've sold a bit higher than you actually wanted to -- great! Meanwhile, you were hedged a bit, with an extra $1 per share in protection the whole time.
Anyone can write covered calls, even in an IRA or tax-advantaged account. You just need to own at least 100 shares of the underlying stock, and can write one call contract for every 100 shares you own. If you're using the strategy on strong, stable businesses at good prices, one main risk is that the stock could soar away on you, since covered calls limit your upside to the strike price plus the option premium.
Strangle still more profits from a stock
For more experienced options investors, there's a way to essentially double your option income while writing covered calls on a stock. The assumption for this option strategy -- called a strangle -- is two-fold:
- You're willing to sell your existing shares if the stock rises above your desired sell price. So you write covered calls.
- You're willing to buy more shares if the stock falls below a certain, desired buy price. So you write puts at the same time.
You're assuming a reasonable price range on a stock, and making money on both sides of it.
Let's assume you own 500 shares of Cisco (Nasdaq: CSCO ) , recently near $22 per share. You'd be willing to sell your shares by January if they're above $24, so you write five covered calls with a $24 strike price. Those calls recently paid $1.15 per share. Now, we also assume at the same time that you'd be willing to buy 500 more shares of Cisco if it fell to $20 or below. So you also write (or "sell to open") five $20 puts that expire in January, paying you another $1.10 per share at recent prices. You've collected $2.25 per share total on your options, equating to a 10.2% yield, or payment, on the current stock price.
Now, if Cisco is above $24 by expiration in January, your shares are called away at your $24 call strike price, but you've actually sold at $26.25 including what the options paid you. Conversely, if Cisco declines below the $20 strike price of your puts, you get to buy 500 more shares at the strike price, but including the option premiums, you're actually only paying $17.75 per share, a great start price on Cisco.
Overall, the math here shows you that as long as Cisco stays in a price range of between $17.75 and $26.25, you make money on this strategy and sacrifice little. The possible downsides are that if Cisco goes above $26.25, you're missing additional upside, and if Cisco goes below $17.75, the new shares you buy begin at a loss (and you'll need to wait for them to recover).
But the wide range for pure profit provided by the strangle, without needing to make any compromises, is sweet -- making this an especially strong strategy to use on blue-chip companies like Cisco, Microsoft (Nasdaq: MSFT ) , or Oracle (Nasdaq: ORCL ) -- and, moving away from tech, perhaps companies such as Pfizer (NYSE: PFE ) , Starbucks (Nasdaq: SBUX ) , or Caterpillar (NYSE: CAT ) .
Like what you own
The main thing to remember when writing covered calls or writing a covered strangle (which is what our second example is called) is to like what you own. If the stock you're writing calls or puts on falls sharply, you're stuck with it. But otherwise, writing covered calls and covered strangles are ways to juice returns on a flat stock or range-bound stock.
To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive The Motley Fool's free educational video series on options, plus my free options guidebook.