Profit From a Stalling Rally

Anybody can make money when stocks are going up, and if you know how to sell stocks short, you can profit when stocks drop, too. But what the heck are you supposed to do in a flat market?

Of course, the market has seemed anything but flat lately. After the market meltdown in 2008 and early 2009, the stock market rallied more than 80%. But in April, stocks started to correct, and there's increasing tension between those who think the rally could resume and others who believe that we're headed back to the lows.

That kind of tension is a recipe for a volatile market that goes nowhere. Consider: After all these gyrations, the market's right back where it was trading in September 2008, just when the market meltdown was getting under way. All told, if you've held stocks since then, you've probably seen a pretty flat performance despite those big swings along the way.

But there's a great strategy that can help you make money even when the stocks you own end up in pretty much same place they started.

Where do I sign up?
Before you get too excited, though, let me point out one thing: This strategy uses options. If you're like many investors, you probably associate options with high risk. Yet used the right way, options can actually reduce your risk -- and that's something this strategy strives to achieve.

The covered call option is one of the simplest low-risk options strategies out there. It lets you earn some extra income from your portfolio while also retaining some of the upside if your stocks keep rising.

To use a covered call, you sell a call option on particular individual stocks you already own. That gives the investor who buys the option from you the right to purchase your shares of stock from you at some predetermined point in the future. In exchange for that right, the buyer pays you a premium -- which you get to keep, no matter what happens in the future.

Show me the money
Often, those premiums are pretty big. If you focus on high-growth companies that many believe will soar, then you can often get paid a lot for writing covered calls. Consider these three candidates, each of which has seen both their earnings and their stock prices grow quickly in the past year:

Stock

Stock Price

Option for Covered Call

Option Price

Netflix (Nasdaq: NFLX  )

125.86

September $140

8.00

Titanium Metals (NYSE: TIE  )

19.93

September $21

1.76

Silver Wheaton (NYSE: SLW  )

20.75

September $22.50

1.15

Source: Yahoo! Finance. As of June 17 close.

Those premiums amount to 5% to 9% of the stock's value -- a nice return over a few months. Moreover, the options shown still let you participate in some of the upside if the shares keep rising.

On the other hand, another good way to implement the covered call strategy is with dividend stocks. The premiums aren't generally as high, but the dividends you'll get paid while you hold your shares will help offset the lower option income:

Stock

Stock Price

Option for Covered Call

Option Price

Chevron (NYSE: CVX  )

74.73

September $75

3.45

Pfizer (NYSE: PFE  )

15.47

September $16

0.50

Verizon (NYSE: VZ  )

29.09

October $30

0.63

Procter & Gamble (NYSE: PG  )

61.76

October $62.50

1.91

Source: Yahoo! Finance. As of June 17 close.

You'll see that those premiums are lower, from 2% to 5% of share price. But each has a dividend yield of at least 3% to further boost your income.

Moreover, you can often use the strategy over and over again. That lets you collect new premiums each time, enhancing your income even more.

As with any appealing investment strategy, 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. If you choose the right options, though, you'll guarantee yourself a profit even if that happens.

Why do it?
Obviously, the covered call strategy works best when:

  • You want to keep owning 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, covered calls give 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. It boosts your income in down markets and locks in gains during bull markets. Moreover, it's a relatively simple introduction to options, which can help you with your portfolio in many ways.

The covered call strategy is just one method that our Motley Fool Pro service has used to deliver strong returns since its launch in late 2008. We're reopening the service to new subscribers for a few days later this month. If you're interested in learning more about how to make money no matter what the market throws at you, along with a free report with five strategies to help your portfolio grow even in a turbulent up-and-down market, just enter your email address in the box below.

This article was originally published June 17, 2009. It has been updated.

Fool contributor Dan Caplinger loves creative options strategies. He doesn't own shares of the companies mentioned. Pfizer is a Motley Fool Inside Value recommendation. Netflix and Titanium Metals are Stock Advisor selections. The Fool owns shares of Procter & Gamble, which is an Income Investor recommendation. The Fool's disclosure policy isn't optional.


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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 June 21, 2010, at 8:04 PM, henryking54 wrote:

    Dan Caplinger wins hypocrite of the year award. In a previous article entitled 'Stay Away From Covered Calls," he wrote:

    "This strategy creates commissions for brokers each time you sell call options. But that isn't the worst thing about covered calls. The main problem with the covered call strategy is that it flies in the face of why you own stocks in the first place. While dividend income can be an important factor in choosing a stock for the long run, a big part of how stocks add value to your portfolio over time is through price appreciation. By using the covered call strategy, you essentially give away your right to future price appreciation above a certain point -- which can be a disastrous mistake in many cases."

    http://www.fool.com/investing/dividends-income/2007/07/12/st...

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