Options? Are You Nuts?!

So how about that stock market rally? You think the recent dip was a speed bump? Or are we looking at another big drop sometime soon?

Personally, I've been skeptical of this rally for months -- the economic "recovery" still looks awfully shaky to me, and I won't be surprised if -- when -- another big shoe drops. But whether we go way back down or not, it seems likely that the volatility is going to be with us for a while.

So in the interest of putting my money where my mouth (er, keyboard) is, I've been taking a careful look at strategies that can generate profits in volatile markets like this one.

I don't mean day trading the volatility -- that's not a strategy with a high chance of success, and anyway I'm too busy (or maybe lazy) to spend every waking minute hovering over market feeds.

I'm looking at something that's easier, safer, and just better: options.

Options? Like, stock options? Seriously?
I know that for many Fools, the idea of entering the options market is a daunting one. For me, for years, as a guy who focused (personally and professionally) on retirement investing, it was one of those things, like day trading currency futures and running Ponzi schemes, that was on the other side of the wall between common sense and greed-fired insanity, one of --

Wait a minute. Stop.

What?

Options? Are you NUTS?!

Do you mean I'm nuts because I'm learning about how to use options? Or nuts because I'm hearing voices in my head calling me nuts?

Listen, I'm here for your own good, or at least the good of your portfolio. Options are for crazy people -- or at least for pros, those guys at Goldman Sachs or wherever who have the super-hyper-fast trading systems and years of experience. You can't compete with those dudes!

I don't need to "compete" with anybody. There are several ways for individual investors to use options to add return to a reasonable, risk-managed portfolio, while --

Y'know, I see those guys on the TV, in those ads talking about how you can make a bazillion dollars trading options at home with their special software or whatever. And you used to tell me to stay away, that for most people options trading is a big-time money-loser just like those foreign currency trading things. Now you're telling me I should learn about options?

Yeah. I'm not talking about "trading options." I'm talking about using them prudently. Just because some people burn themselves doesn't mean fire is always a bad tool, does it?

Seriously, stop. I remember back in the old days how the Fool used to go on about how people should just stay away from options. "Options are to be avoided, period." I bet all that stuff is still in the archives on the site. Now you're telling me that it's OK?

You know what? I used to believe all that stuff, too, and I used to advise folks to just stay away from the options market. But I've been reading Jeff Fischer's options tutorials --

Fischer? Who's that?

He's the lead advisor for the Motley Fool Pro service. Very smart guy. As part of the Pro service, he created a great series of tutorials on ways that smart, non-crazy individual investors -- us Fools -- can use options to make money without undue risk.

I'll give you an example. Do you know what puts and calls are?

Yeah, I know that much. A put is an option that gives you the right to sell a stock at a specific price by a specific time, and a call gives you the right to buy a stock at a specific price by a specific time.

And you know that you can sell options as well as buy them?

You mean like issue them?

Yeah. It's called "writing" options. Anyway, here's the example -- we're going to write something called covered calls as an income-generating strategy. "Covered" means we own the underlying stock -- you never want to write the other kind, called naked calls, because that is an extremely risky strategy.

First, you look for a big-company stock that's fairly stable, ideally one that pays a dividend. If you own any of these stocks, you've already got a good place to start:

Source: Motley Fool CAPS and Yahoo! Finance.

If you don't already own a stock like these, you'd begin by choosing one and buy some. Let's say that you bought 100 shares of McDonald's at $75. You think that while it's unlikely to nosedive, it's not going to go up much, either. Mickey D's pays a pretty good dividend, but now you're going to boost your income stream even further by writing covered calls on it. You can write one call -- each option contract covers 100 shares -- that give someone the right to buy the stock from you at $80 between now and mid-March. Currently, that contract would pay you about $0.83 per share for writing those calls.

So what could happen? There are three possibilities:

• The stock soars. McDonald's takes off and goes way over $80, and someone exercises the calls. It might be selling at $100 in March, but your profits would be limited to the $5 per share from the sale, plus the $0.83 per share you got for the calls, plus any dividends you might collect between now and then. That's still a roughly 8% return in just three months, which isn't shabby at all on a large-cap dividend stock.
• The stock tanks. Well, that's a risk with any stock. But you still made that $0.83 a share, and you can write five more calls after those expire in March.
• The stock is stable. So you held a stable stock during a period of market volatility, collected a dividend, and made an extra $0.83 a share with your calls, which won't be exercised, and you can write another set for another chunk of change in March.

The worst risk here -- aside from the inherent risk of owning the stock you choose -- is that you miss some of the upside if the stock takes off. But if you think the stock is going to take off, it's not a candidate for a covered call strategy.

Huh. I didn't realize that you could use options that way.

Yeah, a lot of people don't. But it's a low-risk way to add some extra income no matter what the market does, and, like I said, that seems like a good idea right now. And you're not competing head-to-head with some supercomputer at Goldman when you do this, either.

And that's just the beginning. Motley Fool Pro teaches you a whole series of strategies that can help you increase your returns and reduce the overall risk of your portfolio. If you'd like to learn more about how to put options to work in your portfolio, just drop your email address into the box below for more information.