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. In April, after the yearlong rally from the March 2009 lows, the market went into a temporary tailspin. Yet when September started, stocks moved upward sharply, catching many seasonally aware investors by surprise.

They've been heading up ever since, and stocks are challenging two-year highs. But there's increasing tension between those who think the rally could continue 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 huge swings in both directions, 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 still 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, especially on stocks that have seen big gains lately. For instance, look at how the strategy would work on the following stocks, each of which is up at least 25% in the past six months, and each of which receives a top five-star rating on our Motley Fool CAPS service:

Stock

Stock Price

Option for Covered Call

Option Price

Ebix (Nasdaq: EBIX  )

24.05

March $25

1.40

Transocean (NYSE: RIG  )

69.28

May $75

3.35

Cypress Semiconductor (Nasdaq: CY  )

18.05

March $19

0.85

Leucadia (NYSE: LUK  )

29.52

March $30

1.05

Chicago Bridge & Iron (NYSE: CBI  )

32.86

April $35

1.74

Vale (NYSE: VALE  )

34.55

March $35

1.73

ArcelorMittal (NYSE: MT  )

37.89

March $40

1.73

Source: Yahoo! Finance. As of Dec. 22 close; all prices in U.S. dollars.

Those premiums amount to 3% to 5% or more of the stock's price -- a nice return over a few months. And often, you can use the strategy over and over again, collecting a new premium each time.

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. It's been closed to new subscribers for 18 months, but in January, the service will briefly reopen its doors. As a limited-time offer, though, you'll need to act fast. To learn more about Motley Fool Pro and how options and other investing strategies can help you make money, just enter your email address in the box below to get the latest information.

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. Cypress Semiconductor and Ebix are Motley Fool Rule Breakers recommendations. Leucadia National is a Motley Fool Stock Advisor choice. Chicago Bridge & Iron is a Motley Fool Global Gains recommendation. The Fool owns shares of Ebix and Transocean.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't optional.


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  • Report this Comment On December 23, 2010, at 4:09 PM, KAPinvestor wrote:

    While the premise of the article is sound, be sure to check out the transaction costs with your broker before putting it into practice, especially with a small number of contracts. Options trades cost money going both ways, and if you are assigned one or more exercises the costs can really eat into your returns.

    What may yield 3-5% when the transaction costs are spread out over a lot of contracts could end up being 1-2% for a single contact with an assigned exercise.

    Before going into a covered call trade, I recommend looking at your potenital return three ways:

    1. Expires worthless (ie: collect premium less trade cost to open the contract.)

    2. Write and buy back (collect premium less trade costs to open and close)

    3. Write and get assigned an exercise (collect premium plus gain between price at opening and strike price, less trade costs to open and costs of assigned exercise).

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