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:

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.