How to Create Big Income on Go-Nowhere Stocks

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You've undoubtedly heard the old adage that a great company doesn't necessarily make a great stock investment.

That's because valuation and forward prospects matter. Big, stable, blue-chip companies are widely followed, their prospects are well-known, their stock prices generally reflect the available information on the company, and they're generally so big, their explosive growth periods are well in their past. In short, they're not going to run away on you.

One options strategy you can use to earn income on a slow-moving stock is known as a diagonal spread. It works something like a covered call -- except that, instead of making a pricey upfront investment in shares of a stock and selling call options against them, you replace the stock purchase with a cheaper long-term call option. Let me walk you through an example or two:

First, find a great company
Some candidates you might consider are Microsoft (Nasdaq: MSFT  ) , which has spent most of the last decade bouncing between $25 and $30, or Wal-Mart (NYSE: WMT  ) , which has spent most of the last decade between $45 and $60.

A personal favorite is snack and fizzy beverage purveyor PepsiCo (NYSE: PEP  ) , a global powerhouse that gushes cash and returns it to shareholders via share repurchases and a steadily rising dividend. Yet long-term returns have been mundane. The 10-year annualized return on the stock alone is 3.3% -- 5.2% if you include reinvested dividends. I believe diagonal calls can offer even more.

Choosing your diagonal options
A diagonal has two components: a purchased lower-strike call that expires as far in the future as possible, and a written higher-strike call that expires in the short term. Generally speaking, you want to implement the strategy on a good name trading at a "fair" valuation. You then want to buy as long-term a call as possible, with minimal "time value" -- that is, the difference between the current stock price and the call's strike price. When in doubt, it's often worth it to be a little defensive with your owned call selection and pay up for a strike price well below the current stock price.

Let's say that I believe UnitedHealth Group (NYSE: UNH  ) is fairly valued today around $44. The January 2013 $25 calls recently selling at $20.25 offer a reasonable balance between minimal time value paid and cash out of pocket. On the short-term written call side, we typically look two to three months out, with a strike price marginally above the current stock price. Recently, writing the June 2011 $45 calls paid us $2.26 per share.

Now, step back and consider your combined position. We've gained exposure to the underlying stock via our long-term call option for considerably less cash than buying the stock outright. If the stock price rises, it will pull the value of our owned calls up with it. Options aren't entitled to dividends (UnitedHealth pays $0.125 quarterly), but our written short-term, higher-strike call offers us far more. Even accounting for differing tax rates on dividends and written calls, the total return on the diagonal trumps straight-up stock ownership for a slow/no moving stock. Here's the comparison if the stock hits the $45 strike at June 2011 expiration:


Stock Ownership


Buy underlying stock or long-term call option $43.82 $20.25
Cash received (dividend or written call premium) $0.125 $2.26
Total Profit -- stock at $45 at expiration $1.31 $3.11
After-tax total return 2% 11.2%

Come June 2011, if UnitedHealth's stock price is at or below the short-term call's $45 strike, that option simply expires worthless, and we retain the still-valuable January 2013 $25 calls. Rather than closing the position, it's a matter of lather, rinse, and repeat: We'd simply write another call with a strike that's similarly above the current stock price. Conversely, if the stock runs above the short-term call strike, the value of the January 2013 call you bought will go up as well. In a worst-case scenario, you can sell the owned long-term call and use some of the proceeds to buy back the previously written call -- and your gains should still be ahead of stock ownership plus dividends.

What can go wrong
Be aware of ex-dividend dates. If the stock price is higher than the short-term call strike, and the dividend payment exceeds the remaining time value the day before the stock goes ex-dividend, your short-term call could be exercised against you, leaving you short in the stock. In such circumstance, you then are responsible to pay the dividend to the opportunist who bought the calls you wrote.

Also, choose your underlying stock wisely. A rip-roaring momentum name like (Nasdaq: PCLN  ) , or a consistently performing growth engine like Chipotle (NYSE: CMG  ) are not good candidate for diagonalization. For these sorts of stocks, buying calls on dips makes more sense. With diagonals, big and boring are your friends. And finally, be aware of the stock price -- if it falls below the long-term strike price, re-evaluate your trade posthaste -- and of taxable transactions. (Consult your tax pro if necessary.)

The Foolish bottom line
Diagonals aren't for everyone, and they take some vigilance. But they can be a worthy tool to enhance your investment income. If you'd like to find out more about how you can use options to boost your returns, simply enter your email address in the box below to receive Motley Fool Options' "Options Edge" 2011 guidebook.

Jim Gillies owns Chipotle. Microsoft, UnitedHealth Group, and Wal-Mart Stores are Motley Fool Inside Value recommendations. Chipotle Mexican Grill is a Motley Fool Rule Breakers choice. and UnitedHealth Group are Motley Fool Stock Advisor recommendations. Wal-Mart Stores is a Motley Fool Global Gains pick. Chipotle Mexican Grill is a Motley Fool Hidden Gems pick. PepsiCo is a Motley Fool Income Investor choice. Motley Fool Options has recommended a diagonal call position on Microsoft. Motley Fool Options has recommended a diagonal call position on PepsiCo. Motley Fool Options has recommended a diagonal call position on UnitedHealth Group. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores. The Fool owns shares of Chipotle Mexican Grill, Microsoft, PepsiCo, UnitedHealth Group, and Wal-Mart Stores. 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.

Read/Post Comments (4) | Recommend This Article (7)

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 March 08, 2011, at 6:35 PM, tpiehl wrote:

    I guess I am brain dead on options but I don't see how spending $20.25 gets me $3.11. Maybe this writer should explain more for us dummies.

  • Report this Comment On March 09, 2011, at 7:14 AM, TMFCanuck wrote:


    As mentioned in the article, if the stock is $45 at June 2011 written call expiration, that call obligation will go away, and you'll still own the Jan-2013 $25 call.

    That call will be worth ~$21.10 (Black-Scholes option pricing model) at that time, with over a year and a half to expiration, and $20 of intrinsic value (i.e. difference between stock and strike price).

    You also earn the written call premium in full.


    Value realized if you then chose to sell the Jan-2013 call = $21.10

    Add: Full value realized for written call = $2.26

    Less: Value originally paid for Jan-2013 call = $20.25

    Net profit (if you closed the trade at that point...which you wouldn''d write another short term call) = $3.11



  • Report this Comment On March 09, 2011, at 9:54 AM, lctycoon wrote:

    If someone exercised that short-term call at $45, couldn't you then exercise your long-term one, leaving you with $2,000 (the difference between the two at 100 shares per option)?

    I know that won't be two grand in profit, but it still seems like you've basically protected yourself from being destroyed because you don't have a naked short call.

  • Report this Comment On March 09, 2011, at 11:22 AM, TMFCanuck wrote:

    Hi lctycoon,

    You COULD exercise your long call in the situation you describe...but you wouldn''d SELL it instead.

    (Or rather, what you'd most likely do is leave your long call alone, and take the cash you received from your written call being exercised against you, plus the cash from writing a NEW call at roughly the current trading price expiring in, say, three months, and then cover your short stock, plus re-establish the diagonal).

    If you were to exercise your long call early - you'd receive its intrinsic value (stock price less strike price), but you'd be foregoing any remaining time value in that call.

    If you SOLD your long call to help cover your short, you'd receive both intrinsic value AND remaining time value from the market sale - in other words, you'd bring in a greater amount of money and would enhance your profits.

    Make sense?

    (I've got four diagonals running right now over in Motley Fool Options - all are healthily profitable and they've been running for some time...feel free to come check out how they work).



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