Earn Higher Returns on These 5 Stocks

Making money in the stock market typically involves "buying low and selling high."

That means buying stocks you think are undervalued, with the expectation that they'll rise. Of course, the higher you set your desired sell price, the greater your potential profits ... but the higher your risk that you won't earn those profits.

But there's one strategy that can enable you to "buy low and sell higher" without taking on extra risk.

Here's how it works
Suppose you own 100 shares of Intel (Nasdaq: INTC  ) . It's a stable company that draws an enormous competitive advantage from its scale, so you don't expect it to collapse overnight. While you wouldn't sell at current prices, with a P/E just below 20 and moderate growth estimates, you don't exactly expect shares to be a quick double or triple. If Intel rose from its current price of $21 per share to $24, however, you'd consider the stock fairly valued, and you'd be willing to sell.

You can use an options strategy known as writing covered calls to increase your effective sell price. When you write a call, an investor pays you money up front for the right to purchase your shares by a certain date at a certain price. In this case, you could receive $0.80 per share for the promise to sell Intel, should it reach $24 by Jan. 21, 2011.

Let's say Intel rises above $24 by Jan. 21. Your shares would be "called away" from you at your target sell price of $24. But because of your $0.80 calls, your effective sell price was $24.80, an additional 4% return on your $21 investment -- earned in just seven months.

Should Jan. 21 roll around without Intel cracking $24, you get to keep your shares, keep the 4% you earned on your calls, and, if you'd like, write new calls.

The downside
Writing covered calls allows you to earn higher returns without having to take on extra risk. Of course, it's still possible your stock could fall in value, but if you write covered calls on stocks you're comfortable owning anyway, that's a risk you were already taking, and the call premium will help to cushion your downside.

The big drawback to writing covered calls is opportunity cost. Should Intel soar to $35, instead of capturing the upside had you simply owned the stock, you'd be locked into your effective sell price of $24.80. But if you were planning on selling at $24 anyways, that might not be a big deal to you.

For these reasons, despite the huge premium that a highflier like Baidu (Nasdaq: BIDU  ) would earn you -- in this case, easily 7% in just a few months -- you probably wouldn't write a covered call on such high-risk high-reward stocks, because you'd be capping your upside while remaining exposed on the downside. (There is, however, another options strategy that you can use to profit, whichever way a volatile stock such as Baidu moves.)

Five stocks for higher returns
What's the ideal stock for writing covered calls to raise your effective sell price? It will belong to a reasonably stable company (to protect your downside), but you won't expect it to soar overnight (so you won't miss out on a huge upside, should you be forced to sell).

Frequently, this means we're talking about stocks that may be somewhat -- though not drastically -- undervalued. Finally, since options premiums are generally higher for more volatile stocks, the strategy can be more lucrative with stable companies that still have moderately high betas.

With those criteria in mind, here are five candidates for writing covered calls on in order to earn higher returns:

Company

P/E

Beta

Honeywell (NYSE: HON  )

15.3

1.31

Johnson Controls (NYSE: JCI  )

17.2

1.96

Agrium (NYSE: AGU  )

19.6

1.54

Legg Mason (NYSE: LM  )

24.2

2.00

Disney (NYSE: DIS  )

18.5

1.25

Data from Motley Fool CAPS. Data as of June 21, 2010.

Make sure you're ready to sell
Writing covered calls to boost your effective sale price is a reliable strategy, especially when used on strong stocks selling at reasonable prices. And in down and sideways markets, covered call income can smooth out and pad your returns. Just make sure you're ready to sell a stock if it gets called away on you.

We're teaching -- and using -- covered call strategies in Motley Fool Pro. We're also employing other option strategies to generate income and achieve better buy and sell prices on our stocks. If you'd like to learn more, simply enter your email below.

Fool editor Ilan Moscovitz owns shares of Disney. Disney and Intel are Motley Fool Inside Value picks. Disney is also a Stock Advisor choice. Baidu is a Rule Breakers recommendation. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Legg Mason. The Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (66)

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 June 22, 2010, at 2:21 PM, henryking54 wrote:

    Fool contributor Dan Caplinger disagrees with you. He strongly recommends AVOIDING covered calls:

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

  • Report this Comment On June 22, 2010, at 3:18 PM, TMFDiogenes wrote:

    Thanks,

    This is Dan's problem with covered calls:

    "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."

    Here's what I sad:

    "The big drawback to writing covered calls is opportunity cost. Should Intel soar to $35, instead of capturing the upside had you simply owned the stock, you'd be locked into your effective sell price of $24.80. But if you were planning on selling at $24 anyways, that might not be a big deal to you.

    For these reasons, despite the huge premium that a highflier like Baidu (Nasdaq: BIDU) would earn you -- in this case, easily 7% in just a few months -- you probably wouldn't write a covered call on such high-risk high-reward stocks, because you'd be capping your upside while remaining exposed on the downside."

    So I don't think we disagree. As with any kind of option, you want to make sure the strategy you use is appropriate for the stock you're working with and for what you're trying to do.

  • Report this Comment On June 22, 2010, at 3:26 PM, henryking54 wrote:

    <<So I don't think we disagree.>>

    Ilan, you either didn't read Dan's entire article or you are being intentional disingenous. First, his article is entitled: "Stay Away From Covered Calls." That is an absolute statement against covered calls. Second, he trashes the idea of writing covered calls on stocks in a trading range because you never know when stocks will break out of their trading range:

    "Stocks can always break out of established trading ranges. Furthermore, with so many stocks with potential for huge price appreciation, keeping a stock specifically because you don't expect it to rise dramatically in price seems silly.

    While the income from covered calls may appeal to conservative investors, it's often not worth what you give up. The potential for lost profits, additional taxes, and constant fees makes the covered call strategy questionable for most investors."

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

  • Report this Comment On June 22, 2010, at 4:10 PM, MaxTheTerrible wrote:

    Besides issues already discussed, another downside of the covered call strategy is that you are stuck with your shares until option expiration date (unless, of course, the options get exercised before expiration - rarely happens in real life). Take your Intel scenario, for example, and say that Intel goes up to $25 BEFORE expiration date, and then goes back to $21. In normal circumstances, if your sell point is $24 (or even $24.80) you would sell and realize the profit, but if you wrote calls you wouldn't be able to do that (without going "naked").

  • Report this Comment On June 23, 2010, at 12:38 PM, sagitarius84 wrote:

    Selling Covered Calls is no free lunch:

    http://www.dividendgrowthinvestor.com/2009/10/selling-option...

    Just look at the charts inside and you will see how a covered call strategy doesn't produce outstanding results over time..

  • Report this Comment On June 23, 2010, at 1:47 PM, plange01 wrote:

    with the depression in the US getting worse by the day you can forget disney..

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