Options? Are You Nuts?!

2011 seems to be opening with a nice rally, but is it for real? Was the dip late last year just a speed bump? Or are we looking at another big drop sometime soon?

Lots of investors have been skeptical of this rally for months -- the economic "recovery" still looks awfully shaky in many ways. Will you be surprised if -- when -- another big shoe drops?

I can't say I will be, but after the last couple of years, nothing would surprise me. But whether we go way back down or not, it seems likely that volatility will be a feature of stock market life for a while longer.

So here's the question: As investors, how can we use that volatility to our advantage? I don't mean day trading -- that's not a strategy with a high chance of success, and anyway most of us are just too busy (or in my case, lazy) to spend every waking minute hovering over market feeds.

Personally, I've been 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 little crazy, more like day trading currency futures and running Ponzi schemes than something that anyone with common sense would --

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 may already have 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 3M at $85. You think that while it's unlikely to nosedive, it's not going to go up too much, either. The Scotch Tape folks' dividend isn't bad, but now you're going to boost your income stream further by writing covered calls on the stock. You can write one call -- each option contract covers 100 shares -- that give someone the right to buy the stock from you at $95 between now and mid-April. Recently, that contract would pay you about $0.81 per share for writing those calls.

So what could happen? There are three possibilities:

• The stock soars. 3M takes off and goes way over $95, and someone exercises the calls. It might be selling at $120 in April, but your profits would be limited to the $10 per share from the sale, plus the $0.81 per share you got for the calls, plus any dividends you might collect between now and then. Even without dividends, that's still a roughly 13% return in just over 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 $0.81 a share, and you can write more calls after those expire in April.
• The stock is stable. So you held a stable stock during a period of market volatility, collected a dividend, and made an extra $0.81 a share with your calls, which won't be exercised, and you can write another set for another chunk of change in April.

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 and instantly receive our "Option Edge Handbook," just drop your email address into the box below.

This article was originally published Aug. 18, 2009. It has been updated.