Profit on a Flat Stock

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:

  1. You're willing to sell your existing shares if the stock rises above your desired sell price. So you write covered calls.
  2. 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.

Jeff Fischer is advisor of Motley Fool Pro, which uses options to complement and enhance stock returns. He owns shares of Oracle. The Motley Fool owns Starbucks. Microsoft, Starbucks, and Intel are Inside Value selections. Starbucks is also a Stock Advisor pick. The Fool has a disclosure policy.


Read/Post Comments (22) | Recommend This Article (75)

Comments from our Foolish Readers

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 August 10, 2009, at 5:12 PM, plange01 wrote:

    flat for years! in spite of all the talk the fact is most stocks are no where near where they were a year ago...

  • Report this Comment On August 10, 2009, at 6:24 PM, starbucks4ever wrote:

    Surely you meant "straddle"? :):):)

  • Report this Comment On August 10, 2009, at 6:36 PM, portefeuille wrote:

    ------------------

    Nick Leeson took short straddle positions when chasing losses he had run up for his employer, Barings Bank. He had initially invested in futures on the Nikkei 225 stock index. Following a dramatic fall in the market, largely due to the Kobe earthquake, Leeson lost millions. He tried to re-coup these losses by investing in the higher risk, but potentially more rewarding, straddles. He bet that the Nikkei would stabilise and stay in a range around 19,000. His bet failed and losses escalated to $1.4bn, causing the bankruptcy of Barings.

    ------------------

    (from here -> http://en.wikipedia.org/wiki/Straddle )

    so the author suggests taking short straddle positions.

  • Report this Comment On August 10, 2009, at 6:51 PM, uncas10 wrote:

    hi great piece about covered writing ... just ask S Kassoff at analytic investment management, newport beach , california he "wrote the book on covered writing ... i helped him a bit regards , frank

  • Report this Comment On August 10, 2009, at 6:51 PM, TMFFischer wrote:

    zloj,

    Nope, I mean strangle. A straddle involves using calls and puts on the same stock with the same strike price (not different strike prices -- different strike prices are strangles). We'll write something about straddles later this week.

    Best,

    Jeff

  • Report this Comment On August 10, 2009, at 6:55 PM, TMFFischer wrote:

    Hi portefeuille,

    Investing -- or betting -- in futures or on an index's short-term move as a whole, and obviously with a lot of margin on Leeson's part, is very different from writing cash-secured puts, where you have the means to buy the underlying stock. When you use options based on your means, and not based on margin, you have no more risk than you do investing in stocks based on your means (actually less, I would argue, since you can target more attractive start or end prices).

    Best,

    Jeff

  • Report this Comment On August 10, 2009, at 7:24 PM, TMFFischer wrote:

    I should add to the above that I'm referring mainly to writing options. Buying options invites more timing risk than just buying a stock (though there are ways to mitigate that, too). Most often, I prefer to write options. It's a consistent strategy.

  • Report this Comment On August 10, 2009, at 7:49 PM, portefeuille wrote:

    sorry, I just glanced at the article. so change straddle to strangle in my comment above.

  • Report this Comment On August 10, 2009, at 9:08 PM, richie54 wrote:

    You people seem to be playing both sides of the street. First, it was buy and hold, assuming you didn't need the money for a minimum of five years. Options are something I have never fooled with. The beauty of online brokerage accounts is that they lowered everyone's costs considerably, and eliminated the inherent conflicts of interest that come with dealing with full-service brokers. Stick with the basics and leave the highly speculative matters to the people who do it for a living.

  • Report this Comment On August 10, 2009, at 9:10 PM, abbie116 wrote:

    So who actually pays the call dividend and how's it's value determined? I take it you know what it is going to be before you place a covered call on your stock.

    Example: say I work for Schlumberger and have 2000 shares. From internal meetings it looks as though we'll be flat the next two years, just based on rig count projections. Could you ladder the call options as a strategy in case some geopolitical event turned the oil industry to the upside?

  • Report this Comment On August 10, 2009, at 11:00 PM, TDUBFISH313 wrote:

    Does anyone know if there is a website where you can practice writing calls and puts without actually investing?

  • Report this Comment On August 10, 2009, at 11:43 PM, UltimateAnalyst wrote:

    go to investopedia.com and join their stock market simulator. You can practice there.

  • Report this Comment On August 11, 2009, at 4:45 AM, michelcolman wrote:

    It is very misleading (actually, downright wrong) to say that a strangle can "essentially" double your profits. You have to realise that you are playing with twice the number of shares as well! If the shares go down dramatically, you don't just lose money on the put but ALSO on the 100 shares you are keeping to cover the call. That's a risk of 200 shares. If the share price goes down to zero, you're stuck with 200 worthless shares, 100 you bought earlier to cover the call and 100 extra from the put.

    So there's nothing magical about the strangle position: you get twice the reward for twice the risk, which amounts to the same return on investment. This is consistent with the "no free lunch" principle which, many people don't seem to know, applies to options as well.

    The main advantage of the (covered) strangle is that it remains profitable over a wider range of share prices, but the flipside of the coin is that, in many cases, two puts or two calls would have given you more profit. (calls if the stock goes up, puts if the stock goes down only a little bit). The same potential profit is just distributed over a wider range of share prices, which makes it a more conservative position. But that's all it does.

    The strangle takes on a completely different character if you decide not to cover the call. Now you really are only "risking" 100 shares, but you lose money if the stock goes up OR down, and the risk is theoretically unlimited on the upside. No free lunch there, either...

  • Report this Comment On August 11, 2009, at 5:47 AM, UsedforPostage wrote:

    This makes sense to me as a supplemental investment strategy, and I'd like to learn more, but I have long been under the impression that the transaction costs of options (futures, etc.) are very high compared to simply buying and selling shares and mutual funds where one typically pays pennies on the dollar at most, making it easy to adjust in small increments over time. The lack of any mention of fees here does not lessen my reservations. A related drawback is that the minimum amounts needed seem large. In the examples of Intel and Cisco given here, the hypothetical investor has circa $10,000 invested per issue. How many moderate income retirement fund investors like me, with widely diversified portfolios, have $10,000 sunk into one single stock? I get edgy if a stock position goes over $5000.

  • Report this Comment On August 11, 2009, at 6:43 AM, PaulH007 wrote:

    I would suggest that with just a modest investment of time that someone owning shares should write covered calls every month going forward. The key thing that you need to bear in mind that the key day of the month is the third Friday. Whatever the price is of the stock at 4pm on that day dictates if you are going to be called or not. While writing monthly covered calls DOES take more time it has the effect of A) increasing annual income from a particular stock, and B) makes it less likely that you will get called away as you can move the 'strike price' upwards reflecting changing market conditions and news relating to your particular company.

    As to the issue of costs I use E-Trade and while there are cheaper online trading companies I like the research that they offer.

  • Report this Comment On August 11, 2009, at 7:46 AM, utahgolf wrote:

    A key mentioned by Jeff is to use this strategy for STOCKS YOU REALLY LIKE! I write (cover) shares on a regular basis and find it hedges my downside. If the shares are called I simply buy long and cover them again! If the shares go down, it's ok because I love the company. If the fundimentals change for the worse, I sell the long after the options expire. I write puts on only a selected few longs and am very careful about that, but do use 'strangles' on occasion.

    Thanks Jeff and MF Pro for making me a better investor!

  • Report this Comment On August 11, 2009, at 10:47 AM, michelcolman wrote:

    Many people don't seem to realise how similar written calls and puts are. In fact, a covered at-the-money written call offers exactly the same profit/loss as am at-the-money written put!

    - stock goes up: call gets exercised (profit limited to option premium), put expires (profit limited to option premium)

    - stock stays the same: profit limited to option premium

    - stock goes down: call expires, but you lose on the shares (loss equal to loss in 100 shares, minus the premium), while the put is exercised (loss equal to loss in 100 shares, minus the premium)

    There's only a difference if the strike price is not at the money: for an out of the money call, you actually win a little bit if the stock goes up towards the strike price, but your profit decreases right away if it goes down. For an out of the money put, your profit only starts changing if the stock drops below the strike price. You can fill in the in-the-money cases yourself.

    But once again, at the money, the two are EXACTLY identical.

  • Report this Comment On August 11, 2009, at 1:22 PM, plange01 wrote:

    with the prime rental season ending in a little over a month and the false stock market rally over the great run in car rentals stocks..car,dtg and htz has ended.these were among the top gainers for 2009

  • Report this Comment On August 14, 2009, at 3:53 PM, FoolForOptions wrote:

    It seems TMF is starting to open it's eyes to the options world and while CC writing can increase income on stocks already owned, I think it is important to note that this can be done without ever even owning the stock.

    Instead of buying the stock itself, you could buy a call at a lower strike price (price you would be willing to buy the stock at) and sell a covered call at a higher strike price (price you would be willing to sell at). This is a Bull Call Spread. In a way this is superior to owning the underlying and writing CC's. In both cases your upside potential is limited but with a Call spread you also limit your downside, so if the stock plummets in value you have no actual shares to lose money on. You only lose what you paid for the lower call option minus what you sold the higher call option for. Since the Call option you bought is more expensive than the one you sold this is considered a debit spread.

    Now this may be getting too technical for this thread but you could also get the exact same results with a Bull Put Spread and take in a credit when you enter the trade. In this trade you buy a put at the lower strike price and selling a put at a higher strike price. This trade is synthetically identical to the Bull Call Spread.

    Of course before doing either of these trades (or any options trades for that matter) you need to understand what the Greeks means and how they can affect the outcome of the trade.

  • Report this Comment On August 15, 2009, at 6:14 PM, ctangus wrote:

    One can also just sell the put side of the strangle. I've been gradually putting cash back into the market since November or so and have been largely doing that by selling cash-covered puts. If exercised I then sell covered calls at a price I'm willing to get rid of the stock.

    This has to be on a stock you want to own and you should have enough cash on hand to afford the option being exercised. (No margin!) If the stock price goes up you keep your premium - it can be 2-3% in a month on some stocks. If the stock goes under the strike price, you've at least bought a stock you like at a discount.

    You potentially lose some upside - e.g. I've been selling puts on STD since April when it was trading at 8.91. I've been making $ but in this case would have been better off just buying the stock outright. However if properly diversified selling puts & covered calls provides steady income & makes your overall portfolio less volatile.

  • Report this Comment On August 16, 2009, at 3:35 AM, memoandstitch wrote:

    Funny you used INTC as an example. Last year I sold a Jan 2009 covered call on INTC with a strike price of $22.5 (the share price then was $23.5). Valuing INTC at $22.5, I was ready to sell but with the same reasoning as Jeff's, I chose to sell a covered call.

    Five months later, my gain turned into huge loss as INTC fell 35%. So substituting an immediate sell with a long covered call is not always a good idea. Jeff's covered call strategy would have lost money if it was done last year.

    I like covered calls but they need precise timing. Last month was a good time for covered calls but not now.

  • Report this Comment On August 22, 2009, at 10:47 PM, HermanPotter wrote:

    Thank you, Jeff.

    You confirm what I've learned to be effective. This year I began hedging my short puts with short calls.

    Fortunately, the company on which I concentrated is WFC.

    ...The strangle takes most of the worry from the market gyrations. It's extremely powerful if the puts are sold when the market is very skeptical and if the calls are sold when the market is too exuberant.

    I like to have about 4 strike prices for the puts and the same for the calls. Buying-to-close some of the positions is a good idea also.

    Regards,

    John

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