Options? Are You Nuts?!

I don't know about you, but I can't shake the feeling that this weird eight-month rally isn't for real.

I've been looking for the best ways to position my portfolio in a market that continues to look peaky, or at least bubbly. For me, that means taking a careful look at strategies that can generate profits in volatile markets. I have a core of great stocks that I plan to hold for many years, but I also have some cash from profits I took recently. I'd like to find a way to put that cash to work.

I don't mean day-trading the volatility. While that can work for some, the odds aren't great -- and I don't want to spend my days hovering over market feeds anyway.

But what has my attention at the moment is the options market.

Options? Like, stock options? Seriously?
I know that for many Fools, the idea of entering the options market is a daunting one. For me, for years, as a guy who focused (personally and professionally) on retirement investing, it was one of those things, like day-trading currency futures and running Ponzi schemes, that was on the other side of the wall between common sense and greed-fired insanity, one of --

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 Morgan Stanley 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 Options service. Very, very smart guy. Good writer, too -- he's great at explaining things clearly. Anyway, as part of the Options service, he created a 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 and hopefully pays a dividend. Any of these would be possibilities:

Stock

CAPS Rating

Dividend Yield

Bristol-Myers Squibb (NYSE: BMY  )

*****

4.9%

Chevron (NYSE: CVX  )

****

3.5%

McDonald's (NYSE: MCD  )

****

3.6%

Altria (NYSE: MO  )

****

7.0%

Merck (NYSE: MRK  )

****

4.1%

Pfizer (NYSE: PFE  )

****

3.5%

Verizon (NYSE: VZ  )

****

6.2%

Data from Motley Fool CAPS and Yahoo! Finance.

Once you've chosen a stock, you buy some. Let's say that you bought 200 shares of McDonald's at $60. You think that while it's unlikely to nosedive, it's not going to soar, either. Now you're going to boost your income stream by writing covered calls on it. You can write two calls -- each option covers 100 shares -- that give someone the right to buy the stock from you at $65 between now and mid-March. Right now, they would pay you $0.95 per share for writing those calls.

So what could happen? There are three possibilities:

  • The stock soars. McDonald's takes off and goes way over $65, and someone exercises the calls. It might be selling at $80 in March, but your profits would be limited to the $5 per share from the sale, plus the $0.95 per share you got for the calls, plus any dividends you might collect between now and then. That's still around a 10% return in 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 $0.95 a share, and you can write two more calls after those expire in March.
  • The stock is stable. So you held a stable stock during a period of market volatility, collected a dividend, and made an extra $0.95 a share with your calls, which won't be exercised, and you can write another set for another buck or so a share in March.

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 Options teaches you a whole series of options 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, just drop your email address into the box below for more information.

This article originally ran on August 18, 2009. It has been updated.

Fool contributor John Rosevear has no position in the companies mentioned. Pfizer is a Motley Fool Inside Value recommendation. The Motley Fool has a non-optional disclosure policy.


Read/Post Comments (9) | Recommend This Article (15)

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 December 13, 2009, at 10:07 AM, tkell31 wrote:

    Nice article, but too restrictive on the use of covered calls. Stable dividend stocks pay the smallest premiums. Yes if you are extremely conservative that is probably for you. However, if you are willing to do some work you can reap significantly greater rewards.

    IMO the key is finding stocks you like regardless of the dividend. At that point start checking the option chains to find out which pay the largest premium while allowing the largest stock appreciation growth. Also when selling options it is in your best interest to keep the time period at 60 days or less to take full advantage of the delta/time decay impact on the option price.

    Stick to stocks you like

    Look for spikes in price to sell calls and dips in price to sell puts since most stocks trade in a range and by selling at those points you will maximize your premium and the instinct is to do the opposite.

    Stay under 60 days when selling options to take advantage of the time decay/delta.

    Dont be afraid to buy back the option, but try to resist the temptation unless there is a reason for the price change that is not likely to change.

  • Report this Comment On December 13, 2009, at 1:29 PM, playsitsafe wrote:

    There's an additional "risk": suppose the stock starts tanking and you want to get out? Writing a call means you must maintain your position in the stock until expiration unless you buy that option back.

    For example, your stock (call it ZXW) is trading at 22, and you sell the June 25 Call to get your 0.95 or whatever. Suddenly, bad news pops up for ZXW (they're the world's top okra canner and a freak storm has wiped out 75% of the next year's okra crop) and you want to beat the rush to the exit. You manage to sell at 20 1/2, grateful as you see it slide below 16 - but that option, your commitment to sell it for 25, is still out there.

    At this point, you must grit your teeth and pay the premium (it'll only be around 0.20, say) to buy it back. Because as bad it might seem for ZXW (the CEO just disappeared with the company jet chasing her Peruvian paramour again), you are still in a "naked" position - and if in May, ZXW announced Google was buying their okra-canning technology to implement on their newest phone (called "Nexus Gumbo"), and the stock shot up to 87, you'd still be stuck with having to sell it to someone at 25 - or an option worth -61 to you.

    That would suck.

  • Report this Comment On December 13, 2009, at 3:10 PM, bellbell63 wrote:

    Options are a zero sum "game". So if 90% who buy options lose money (so they say) then that money must be going to the other side of the trade, i.e. the writers. So get on the "house" side, be a writer - covered calls are a good place to start.

  • Report this Comment On December 13, 2009, at 3:14 PM, bellbell63 wrote:

    "You manage to sell at 20 1/2, grateful as you see it slide below 16 - but that option, your commitment to sell it for 25, is still out there."

    That would be foolish - you can close the postion all at once with one order at most brokers so you are never naked, even for a minute.

  • Report this Comment On December 13, 2009, at 6:44 PM, tkell31 wrote:

    Play I dont think you understand how options work because once you buy the option back you no longer have any exposure. Frankly, if you worry about obscure scenarios like that options probably arent for you.

    Bell, agree 100%...it is good being the house. I'm waiting for some to expire on the 19th so I can write some for January. APWR puts at 15 and 17.50 look pretty good right now. No major news expected to cause a price drop.

  • Report this Comment On December 13, 2009, at 6:47 PM, tkell31 wrote:

    My bad, read that wrong play, but you have to admit even in your scenario you will still make more money selling the call then if you hadn't...as the price declines so will the premium on the call allowing you to buy it back for less then you sold it for. Still going to lose money overall, but you would have lost that money just owning the stock in the first place.

  • Report this Comment On December 14, 2009, at 6:11 AM, jimrice57 wrote:

    You missed a very important aspect of the Covered Call and that is should your stock be called away - as it goes up and your written call is exercised you also have to pay the dividend for that stock as well - a risky issue that catch's people all the time. If you want to help someone with options teach them how to use put's to protect themselves or short (put) the stock. Teaching people about covered calls only takes money away from people - that why so many brokerage houses LOVE to teach it.

  • Report this Comment On December 14, 2009, at 9:44 AM, khorner wrote:

    Another thing...you shouldn't write a covered call for a stock you aren't willing to get called away.

    The better play would be to sell the call at the money ($60) giving you a better premium that is all time based and more downside protection. When coming up to expiration, you can buy back if you want to keep the stock or roll up (or down, depending on underlying movement) to another strike price.

    As an option player, you want to sell time value (which deteriorates) and buy intrinsic value.

  • Report this Comment On December 14, 2009, at 10:38 AM, PeyDaFool wrote:

    I propose we start labeling these reports as "revisited," so I don't have to read the first three paragraphs, wasting my time, before I figure out I've read the article once (or often twice) before.

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