Better Than Buy and Hold

You want more, and you deserve better.

The '90s rocked like Bono, and your investments in blue-chip companies paid off. Hard work and savings were rewarded. The next decade, though? Well, the "aughts" rocked more like Hasselhoff. In fact, some have called the years 2000-2010 a "lost decade" for stocks, because each $1 you invested over that time magically turned into $0.76. (Including dividends, investors nearly broke even over that time frame.)

So what can we learn from the past decade? Well, first and foremost, those years were a clear sign that the traditional strategy of "buy and hold" (or "buy and hope," as it was for many) was not the best way to go. Yet it's what we've all been taught to rely upon for years. So where do we go from here?

Consider your (call) options
Your best option (pardon the pun) might be to consider covered-call options. Over the so-called "lost decade," using this strategy trounced the S&P 500 by 53 percentage points, and with less volatility. Using a simple covered-call strategy, that $0.76 you earned could've been $1.29 instead. Intrigued?

Source: The Chicago Board Options Exchange.

A crash course in covered calls
Don't be intimidated by the terminology; a covered call is actually one of the simplest of options strategies. In essence, it's a combination of two things: a stock you own and a call option contract you sell regarding that stock. Here's how the two dance:

  1. The stock: You own it! If it goes up, you win; if it goes down, you lose.
  2. The call option: It's an agreement you enter into. You promise to sell 100 of your shares of the stock if its price rises above a level you choose (called the "strike price"). (The call is "covered" because you own the underlying stock. Otherwise it would be "naked," which -- as the name implies -- is much riskier.)

Think about it for a minute, and you'll see that there are two apparent downsides to a covered-call scenario:

  1. Since you own the stock, you lose out if its price falls (you face this risk even if you don't mess with the call option).
  2. Your covered call requires you to sell the shares in question at the strike price you've chosen. So if your stock rockets skyward, you've given away any profit you stood to make beyond that strike price.

You can do better ...
Yet I've just said this strategy beat the market handily from 2000 to 2010. How? As the seller of the option you get to choose the terms (the strike price and the expiration date) and the option's buyer pays you some cold, hard cash (the "option premium") for entering into the arrangement. Of course, you'll want to make sure the option premium is high enough to sufficiently compensate you for the risk you take. In general, such premiums aren't too difficult to find.

The fancy blue line in the chart above tracks the CBOE S&P500 BuyWrite Index -- an index that pretends to invest in the S&P 500 and write call options that expire in 30 days. At the end of that period, it does the same thing over again. The "BuyWrite" name comes from the act of buying the S&P and then writing call options. Since the index fairy created the BuyWrite index, it has bested the S&P through both up and down markets, thanks to its ability to generate that little bit of extra option premium each month.

... even better than Robocop
Attempting to employ the BuyWrite strategy day in and day out, Robocop-style, is a tall order. But even if you don't happen to be a crime-fighting cyborg, using covered calls as a supplemental strategy to picking great stocks could actually bring you even better results than the BuyWrite Index's blind writing and rewriting covered calls.

Large, stable, quality businesses trading at reasonable prices make the best covered-call candidates. Their stock prices tend not to soar or crash, so the possibility of losing money (either from a plummeting stock or a too-low strike price) is relatively remote. Plus, owning these blue-chip companies is a good strategy in its own right; they make great ballast for your portfolio, and they often pay a dividend. Writing a series of covered calls over the course of a year can boost your returns on such companies by 10% to 15%.

Here are a few covered-call candidates that offer attractive annualized yields:

Company

Dividend Yield

January Strike Price

Upside Retained

Option Premium Annualized Yield

Visa (NYSE: V  ) 0.8% $80.00 3.9% 18.5%
Halliburton (NYSE: HAL  ) 0.9% $45.00 9.1% 16.1%
Home Depot (NYSE: HD  ) 3.0% $35.00 4.6% 12.3%
General Electric (NYSE: GE  ) 2.9% $17.50 5.2% 11.0%
3M (NYSE: MMM  ) 2.4% $90.00 3.7% 10.7%
Walgreen (NYSE: WAG  ) 2.0% $40.00 7.9% 8.0%
United Parcel Service (NYSE: UPS  ) 2.6% $75.00 4.6% 6.7%

Sources: Yahoo! Finance and Capital IQ, a division of Standard & Poor's. Options pricing as of Dec. 3, 2010.

Income delivery
Let's look at UPS as an example of how writing a covered-call option might play out. The stock is currently selling for $71.71. Recently, we could sell a $75 covered call expiring in January 2011 for $0.60. Here's what would happen over the next year:

  • Since we own the stock, we gain or lose according to its performance, all the way down to $0 and up to 4.6% above its current price ($75 is 4.6% more than $71.71).
  • Selling the January $75 call option brings us $0.60, which we can think of as a 0.8% "extra dividend" of sorts.
  • We repeat this strategy every few months, so that "extra dividend" boosts our results by 6.7% (the 0.8% annualized).
  • In addition, UPS pays a $1.88 dividend each year, so that adds 2.6% more in returns to our pocket.

If all goes well, we could earn 4.6% from share appreciation, 6.3% from writing a series of call options, and 2.6% in dividends for a total return of 13.5%. That's enough performance to give Bono return-induced vertigo!

This example highlights why it's so important to be familiar with the underlying business when you write covered calls. If we're right about UPS being a quality business that'll grow over time, we'll pocket some extra income. But what if things don't work out like we've planned; if, say, UPS remains flat or even declines?

Well, it's kind of a trick question. In such cases, we'd still likely end up ahead, because of the added income we gained from writing our covered-call options. Besides the possibility that shares would fall dramatically, the only real downside we face would come if UPS were to fill its gas tanks with rocket fuel instead of unleaded, sending its shares to the stratosphere -- we'd miss out on all the gains above $75.

The Foolish bottom line
Because of the income they bring and the defensive power they can add to a portfolio, covered calls have approximately doubled the return on the S&P 500 over the past 20 years. Combining covered-call writing with solid stock selection and a buy-and-hold mentality is a Foolish recipe for even better performance -- making you extra money on quality companies while letting you sleep well at night.

To learn more about the profitable options strategies we've been using in real-money portfolios for y ears, simply enter your email address in the box below to receive information on Motley Fool Options, plus our free options guidebook.

Bryan Hinmon doesn't own shares of any companies mentioned. Home Depot and 3M are Motley Fool Inside Value recommendations. UPS is a Motley Fool Income Investor recommendation. The Motley Fool owns shares of UPS. 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 Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (27)

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 06, 2010, at 5:58 PM, stan8331 wrote:

    Options are a perfectly legitimate investment vehicle, but you're not helping your cause by repeating that canard about the supposed death of a buy and hold strategy. It has always been true that if you perversely buy stock at the top of a bubble and then refuse to ever buy more as prices fall, it can take a very long time to get back to profitability. It's a meaningless "fact" that's based on disingenuously TRYING to lose as much money as possible to prove that the fundamental rules of investing no longer apply.

  • Report this Comment On December 06, 2010, at 6:42 PM, rdebo wrote:

    Did you mean the January 2012 option? The article mentioned here what could happen over the next year.

  • Report this Comment On December 06, 2010, at 6:45 PM, rdebo wrote:

    Correction, the article was posted in 2010

  • Report this Comment On December 06, 2010, at 7:09 PM, neamakri wrote:

    Okay, I'm trying to follow your UPS example. The new purchaser would break even at $75.60 in two months. That is a price increase of 5.42% in two months. That compunds to over 37% annual increase.

    Where is this person who thinks that UPS will increase over 37% in a year? ...and why don't they just buy the stock outright in the first place?

  • Report this Comment On December 07, 2010, at 9:41 AM, TMF42 wrote:

    Hey Fools, thanks for reading!

    I'll try and address these comments one by one...

    ------------------------------------------------------------

    stan8331:

    The purpose of the article was simply to call to light that investors need to think about their holdings, because often it makes sense to employ a covered call strategy. Buy, hold and hope is a dangerous game. Investors need to take "the next best action" based on what they know and how the underlying business is performing. I'm simply making the plea to consider other options, especially after the returns of the past decade.

    ------------------------------------------------------------

    rdebo:

    I did mean the January 2011 call option, which is why the option yield is so low (0.8%). Becasue the table cited the annualized yield of that Jan11 option and the annual dividend, I phrased the sentence in terms of performance voer an entire year. The assumption (clearly simplified) is that one would be able to repeat the covered call several times over.

    ------------------------------------------------------------

    neamakri:

    Because a covered calls strategy involves selling a call option, we're paid the income -- in the UPS case $0.60. So to breakeven by January 2011 expiration, UPS stock needs can decline to $71.11 ($71.71 - $0.60). The $75 strike price was chosen precisely because I wanted to let UPS shares have a little room to run between now and January expiration -- but not because I expect the shares to soar 37%! If that were the case, you're right, don't cover the shares!!!

    Bryan

    TMF42

  • Report this Comment On December 07, 2010, at 9:50 PM, sundaysam wrote:

    selling a call option = buying a put option?

  • Report this Comment On December 08, 2010, at 10:18 PM, scanlin wrote:

    Good covered call screener here:

    http://www.borntosell.com

    They also have a covered call tutorial, newsletter, and blog.

  • Report this Comment On December 11, 2010, at 4:58 AM, Alijac wrote:

    Bryan, it's ok for you [one] to give United Parcel Service a little headroom to run between now and January, but that can only be construed as being the UPSide, whereas what stan8331 said still 'holds', for my money, in my 'buying' into it [the debate, not UPS per se], c'OZ' one must never neglect their dOWNside altogether either.

    I don't think anyone thought for a moment that you really believed the shares would hit 37%. If they[certain persons, and the shares] did, that could only have been described as being a sore/soar point with you perhaps?

    Your finale back@ neamakri does not quite cover everything methinks c'OZ' if one has enough spare funds [and dyslexicographer talent] it might be prudent to not only still cover any risk... but one's arsehs too..!

  • Report this Comment On December 11, 2010, at 9:34 AM, lqs101 wrote:

    i had the same question as neamakri, which i don't think you answered bryan. why would anyone buy a covered call option, when they can just put in a buy order for ups at the $75 price, without paying the premium?

  • Report this Comment On December 11, 2010, at 2:20 PM, aleax wrote:

    @lqs101, buying a call (whether it's covered or naked is the writer's business and makes no difference whatsoever to the call buyer) requires much smaller amounts of funds than buying the underlying, so you get much more leverage (thus bigger returns or losses).

    Take UPS currently selling for $71.71 with Jan 11 75 options selling for 0.60. If you buy 100 shares, that costs you 7171 (plus commissions). Say the stock soars to 80: then you've made (8000-7171)/7171, 11.5%. If you buy, say, 5 calls, that costs you only 300 (again, plus commissions). If the stock soars to 80 by expirations your calls will be worth at least 5 each (the amount by which they're in the money), so you'll have made (2500-300)/300, 733%. Of course, if the stock does not soar but only rises slightly, say to 73, as a stock buyer you've still made (7300-7171)/7171, 1.8% -- if you own calls they'll expire worthless, so you've lost 100% of your $300 cost.

    Buying calls (especially short-term, OTM ones) is highly speculative and can make huge returns if the underlying soars, but is more likely to lose the invested amount (a still highly leveraged but less aggressively speculative strategy involves buying ITM calls with somewhat longer lifetimes). But some people (maybe more traders and speculators than investors;-) just love the prospects of unlikely but potentially huge gains, so there's most always a ready market for such instruments.

  • Report this Comment On December 11, 2010, at 2:32 PM, aleax wrote:

    @Bryan, I love me some options, but it should be pointed out that buy-write outperformed buy and hold over the last decade roughly *because* the market went sideways through it (and with enough volatility to often offer decently good premiums).

    If you backtest the strategy to the '90s, you'll find buy-write in that decade badly underperformed just holding the index -- too many high-growth large caps would keep being called away, removing too much of the available gains to be made up by the premiums.

    (Buy-write was still fine if focused exclusively on value stocks, by a prudent investor eschewing very high P/E momentum stocks -- being value-oriented throughout the '90s missed a lot of gains anyway, of course, but at least for that specific style of underlying stocks the premiums did help a bit;-).

    If you smell a secular bull or bear market you may be better off with a straight long or short stance; buy-write is at its best in a sideways market (butterflies, condors, &c, may be even better then, but of course we don't want to get into really advanced strategies of that nature here;-).

  • Report this Comment On January 13, 2011, at 5:57 AM, shebiii wrote:

    Just seen this article and it seems ideal for me. I have had a number of ftSE100 shares for quite a while and in total they haven't gained much over time. Where would be a good institution in the UK to trade these - most competative price, easy to use screens etc.

    Many thanks

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