2 Tools to Profit in a Slow Market

What's your favorite stock?

Seems like such a simple, harmless question, right? But suggesting the one perfect stock that's good for any portfolio is a pretty tall order. It's no wonder Warren Buffett takes a pass on throwing out individual stock ideas.

While it's fun to trade individual stock tips and track their daily fluctuations, it's better to look beyond individual stock performance and focus on constructing market-beating toolboxes.

Huh? What's a toolbox got to do with investing?
Every investment is a tool designed to help us earn our desired returns. The combination of all of our investments -- our portfolios -- shows us what tools we really have in our toolboxes.

Just as a man with a hammer sees everything as a nail, having only stocks in our portfolio toolbox limits our ability to tackle uncooperative markets. That's why it's important to fill your box with the kind of gear that can keep your profits humming.

ETF power                                                             
One increasingly powerful tool is exchange-traded funds (ETFs). What are ETFs? Simply put, imagine that a mutual fund and a common stock got together and had a baby.

Like mutual funds, ETFs can offer investors both broad and narrow exposures to specific industries, sectors, or investment strategies. However, since they trade like stocks, ETFs are also an accessible, liquid, and tax-efficient way to plug those holes of fear in your portfolio.

See inflation around the corner? Maybe the SPDR Gold Trust (NYSE: GLD  ) or iShares Gold Trust (NYSE: IAU  )  is for you. Oh, I'm sorry -- you also want to be able to actually redeem your shares for actual gold? Then maybe you want to listen to gold bug and Motley Fool analyst Andrew Sullivan when he calls Sprott Physical Gold Trust (NYSE: PHYS  ) "the best physical gold vehicle on the market."

OK, ETFs might be a great way to diversify and an easy way to gain exposure to very specific types of investments, but can you make any real money investing in them? Well, hold on to your socks.

Just to take a personal anecdote, back in late 2008, Motley Fool Pro's Jeff Fisher recommended Vanguard Emerging Markets ETF (NYSE: VWO  ) , a passively managed, low-cost ETF that essentially tracks the MSCI Emerging Markets Index because he thought emerging markets would recover more quickly than developed markets. Investors who heeded Jeff's advice have an investment that is up more than 110% and is beating the market by more than 60%. In January, Jeff sold half of his position due to valuation concerns, though he continues to hold the other half. (Note to self: Listen to Jeff Fisher more often than I already do.)

Options opportunities
While options can appear to be scary at first, they're probably one of the most underused tools for cautious investors. While the lion's share of reporting on options tends to focus on the more speculative trades, there are numerous strategies well-suited for the conservative investor.

One popular options strategy involves writing covered calls. In this scenario, you own shares of a company that you believe in but that you also think will be stagnant going forward. You can write calls on the stock for a predetermined sell price. That gives the buyers of those calls the right to buy them from you at that predetermined price while the option is current.

If the price goes above the target price, you're obligated to sell at the predetermined price, and you forfeit any profits above it. However, you've already earned a little more through the calls themselves, offsetting any forfeited gains.

If the price stays steady, you keep your shares as well as the income the calls generated.

In other words, covered calls are the ideal tool for investors who want to essentially lower their cost basis on stagnant stocks in their portfolio.

Making stocks pay dividends
Covered calls can also be used to goose the near-term payout of stocks you already own or make stocks that don't pay dividends synthetically do so.

Take, for example, shares of 3M (NYSE: MMM  ) , which currently pay a 2.4% dividend and are priced just below their 52-week high. The company has held up strong throughout the recession and has continued to grow in emerging markets. At current prices, the stock is neither a screaming buy nor sell. Assuming 3M's stock stays range-bound over the year, writing (selling) a January 2012 $95 call could reap you an almost 5% payout on top of the dividends the company already pays you.

Or what about Zimmer Holdings (NYSE: ZMH  ) ? Although the stock has rebounded recently, shares rest roughly halfway between its 52-week high and low and appear reasonably priced. And like several other medical-device makers, Zimmer skimps on the dividends. So, if you own shares of Zimmer, believe it's fairly or slightly underpriced, but would like to get paid a dividend, writing a covered call may be for you. Assuming you don't mind potentially having the stock called away from you, selling a January 2012 $55 covered call would create an artificial dividend of more than 10% for a stock that doesn't even pay one!

The Foolish bottom line
We don't advocate using ETFs or options to speculate, but we believe investors can use them intelligently to help create a portfolio that is relatively resistant to the market's temperamental whims.

How do we know? Jeff Fischer and company at Motley Fool Pro have built a ridiculously impressive track record using stocks, ETFs, and options -- they've posted better than 38% returns with just half of the S&P 500's volatility. If you'd like to find out more about ETF and option strategies for growing your wealth in a volatile, range-bound market -- just enter your email address in the box below.

This article was originally published June 16, 2010. It has been updated.

Andy Louis-Charles is an equity analyst for Inside Value, Special Ops and also manages the ALOHA real-money portfolio. 3M is a Motley Fool Inside Value pick. The Fool owns shares of Sprott Physical Gold Trust ETV, and Vanguard Emerging Markets Stock ETF. 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 Motley Fool has a disclosure policy.


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  • Report this Comment On December 29, 2010, at 7:50 PM, scanlin wrote:

    I agree with you on writing covered calls. Been doing it a long time with good success. Helps to have a screener (saves lots of time). I like http://www.borntosell.com, but there are others.

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