This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Do options scare you?
They scare a lot of folks. Stock options -- the kind that are traded on exchanges -- have acquired a reputation for being dangerous and unpredictable, a thing that sensible investors should file in the same (circular) folder with ideas like "day trading" and "putting all of your money in a big pile and setting it on fire."
The reputation isn't entirely unjustified. "Options trading" tends to work out as badly as "day trading" for many who try it, and to some extent options have been tarred by the same brush that made "derivatives" a bad word after the Great Bank Explosion of 2008.
But I think options' bad rep is overblown. With a little knowledge and care, options can be very useful tools -- even for conservative investors.
A helpful tool in uncertain times
Options are contracts that allow (but don't require) you to buy or sell something at a specific price on or before a specific date. Most investors will deal with standardized, exchange-traded options on stocks or indexes, which come in two basic flavors: puts and calls. A call allows you to buy (or "call away") a stock at a particular price, and a put allows you to sell it -- at your option (hence the name).
You can buy puts and calls through just about any discount broker, or you can create and sell them -- a process called "writing" options. Either way, it's usually only slightly more complicated than buying a stock -- you'll have no trouble figuring it out. The options you buy (or sell) are good for a set time period, after which they simply expire if unused. Those are the basics. Sounds simple, doesn't it? But if you think about it for a minute, you can see a whole range of possibilities.
At the simplest level, options are a low-cost way to take a position if you think a big move is coming. Think banks are in for another round of trouble, but don't want the risk of a big short position? Buying puts on Bank of America
But we're just scratching the surface. How about a low-risk (really) way to boost the returns from your dividend stocks in times when the market doesn't seem to be going anywhere? Like, say, now?
An options strategy for the rest of us, right now
We all know that a stock that pays a good solid dividend through good times and bad is a great thing to have. Great dividend stocks like pharma giant Johnson & Johnson
This is a simple strategy that any investor can use, even in an IRA account. "Covered" means that we own the underlying stock -- that's what makes it low-risk -- and we're writing calls, which means that we're selling someone else the right to "call away" stock we own at a preset price.
The nuts and bolts of covered calls
The first step is to choose a suitable stock, a company you like, but not one that's likely to see major growth. This can be a stock that you already own, or you can buy one. Let's say that you bought 200 shares of McDonald's
How could this play out? There are three possibilities:
The stock goes way up. Surprise! The unexpected popularity of the shocking new Eel McNugget propels Mickey D's stock to a whopping $110 in January. But alas, your upside is limited -- your shares get called away at $95. Still, you make $10 a share in profit, plus the $1.15 a share you got for writing the calls. That's a 13% gain right there, plus any dividends you collected -- not too shabby for a blue-chip stock you held for only three months.
The stock takes a nosedive. Or maybe the Eel McNugget is an epic flop, the stock falls to $60, and your calls expire unused. That's a risk with any stock. But at least you made that $1.15 a share, and you can write another set of calls in January.
- The stock price stays more or less flat. It goes up a little, or down a little, but not over $95, and your calls expire unused. Congratulations! You held a stable stock during a time of market uncertainty, and got some extra cash via those calls (and maybe a dividend, too).
The upshot: An incremental advantage
As you can see, the biggest risk with a covered call strategy is that you'll miss some of the upside if the stock suddenly takes off. But you'll still profit -- and if you think a stock is likely to take off, it's not a candidate for this strategy.
Writing covered calls isn't going to make you a fortune overnight. But think of it this way: A stock like McDonald's is worth owning for its steady, incremental growth and a solid dividend yield of about 3%. If you buy McDonald's at $85 and write covered calls on it four times a year for about $1 each time, that 3% yield becomes more like a 7% or 8% yield -- for a total of maybe 30 minutes of added work over the course of a year. Wouldn't you like to own a stock like that?
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.