Profit From the Stalling Rally

Anybody can make money when stocks are going up, and if you know how to sell stocks short, you can profit when stocks drop, too. But what the heck are you supposed to do in a flat market?

Of course, the market has seemed anything but flat lately. After a plunge early last year to 12-year lows, the stock market has rallied more than 70%. But in recent days, stocks seem to have hit a ceiling, and there's increasing tension between those who think the rally could continue and others who believe that we're headed back to the lows.

That kind of tension is a recipe for a volatile market that goes nowhere. Consider: After this 70% rally, the market's right back where it was trading in September 2008, just when the market meltdown was getting underway. All told, if you've held stocks since then, you've probably seen a pretty flat performance despite those big swings along the way.

But there's a great strategy that can help you make money even when the stocks you own end up in pretty much same place they started.

Where do I sign up?
Before you get too excited, though, let me point out one thing: This strategy uses options. If you're like many investors, you probably associate options with high risk. Yet used the right way, options can actually reduce your risk -- and that's something this strategy strives to achieve.

The covered call option is one of the simplest low-risk options strategies out there. It lets you earn some extra income from your portfolio while also retaining some of the upside if your stocks keep rising.

To use a covered call, you sell a call option on particular individual stocks you already own. That gives the investor who buys the option from you the right to purchase your shares of stock from you at some predetermined point in the future. In exchange for that right, the buyer pays you a premium -- which you get to keep, no matter what happens in the future.

Show me the money
Often, those premiums are pretty big. Take a look at some recent call option prices on some well-known stocks:

Stock

Stock Price

Option for Covered Call

Option Price

Wal-Mart (NYSE: WMT  )

53.86

June $55

1.56

Research In Motion (Nasdaq: RIMM  )

63.89

June $70

4.15

IBM (NYSE: IBM  )

130.25

April $135

2.49

Johnson & Johnson (NYSE: JNJ  )

65.15

April $65

1.57

AT&T (NYSE: T  )

25.83

July $27

0.80

Dell (Nasdaq: DELL  )

14.51

May $15

0.94

Bank of America (NYSE: BAC  )

16.49

May $18

0.68

Source: Yahoo! Finance. As of Jan. 20 close.

Those premiums amount to 2% to 7% or more of the stock's price -- a nice return over a few months. And often, you can use the strategy over and over again, collecting a new premium each time.

As with any appealing investment strategy, there's a trade-off. In exchange for the premium you receive for writing the option, you risk having to sell your shares if they go up in price. If you choose the right options, though, you'll guarantee yourself a profit even if that happens.

Why do it?
Obviously, the covered call strategy works best when:

  • You want to keep owning shares of a stock.
  • You think it will hold its value over time.
  • Even though it's attractive now, you don't think its price will rise too much between now and when the option you write expires.

In a sense, covered calls give investors a no-lose scenario: Either you get some extra cash to hold onto shares you already want to own, or you get paid an instant profit in a relatively short period of time. It boosts your income in down markets and locks in gains during bull markets. Moreover, it's a relatively simple introduction to options, which can help you with your portfolio in many ways.

The covered call strategy is just one method that our Motley Fool Pro service has used to deliver strong returns since its launch in late 2008. Later this month, we're reopening the service to new subscribers. If you're interested in learning more about how to make money no matter what the market throws at you, just enter your e-mail address in the box below.

This article was originally published June 17, 2009. It has been updated.

Fool contributor Dan Caplinger loves creative options strategies. He doesn't own shares of the companies mentioned. Wal-Mart is a Motley Fool Inside Value selection. Johnson & Johnson is an Income Investor selection. The Fool's disclosure policy isn't optional.


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