How to Strangle More Profits Out of Your Winners

Happy anniversary! Just two short years ago, the S&P 500 hit its closing crisis low of 676.53. Since that bleak day, the index has risen a whopping 94%.

Chances are, you've had some winners along the way. Now that the markets have returned to a range closer to fair value, you aren't sure what to do with them. Consider using options to strangle more profits out of your winners.

Writing covered strangles
A covered strangle combines three investment positions, achieving its maximum rewards with a mild upward move in the stock. It sounds complicated, but it isn't:

1. You own 100-share blocks of a stock.
2. You write out-of-the-money call options.
3. You write out-of-the-money put options.

That's just a fancy way of saying that the stock's current price hovers between the two strike prices you choose -- essentially, your put and call options "strangle" the current stock price.

Let's take consumer-products giant Procter & Gamble (NYSE: PG) as an example. Shares currently trade for $62, near your estimate of intrinsic value of $65. You love P&G's 3.1% dividend, but think shares are probably range-bound while the company spends heavily to market its brands during a still-weak economy. Setting up each of the three legs above would say the following:

1. PG is an investment you're comfortable with, and which you think has limited downside.
2. You'd be happy to own more shares if they fell a little bit, say, to $60. (Write a $60 put.)
3. You'd be happy to let your current shares go if they rise to fair value — $65. (Write a $65 call.)

And for taking that stance, a covered strangle allows you to keep the dividend, retain the stock's upside until it hits the strike price of my written call, and earn option premium on both the written put options and the written call options.

How could it play out?
There are three ways your covered strangle could play out. If shares fall more than $2, below the strike price of your written $60 puts, you'd be obligated to buy more shares. Alternatively, if shares rise more than $3 at expiration, you'd be obligated to sell your existing shares at $65. Finally, if shares bop between $60 and $65, you hang onto your existing shares. In each case, you get to keep the option premium you were paid up front for writing the puts and the calls.

As you can see, a covered strangle gives a wide profit range while paying you healthy income.

Finding candidates to strangle
When considering a covered strangle, you first have to be OK with the possibility of owning more shares at a cheaper price, or potentially selling your existing shares if they rise. And remember, you already own shares (and are committing to potentially buy more) so you should choose a healthy stock that you feel has limited downside. And because you own shares over the life of the strangle, it pays to find stocks that will throw a dividend payment your way, too. Here are a few that fit the bill:

Data provided by Capital IQ, a division of Standard & Poor's.

What can go wrong?
The main risk of writing covered strangles is that you take on the downside risk of additional shares. If the stock you've chosen tanks, your owned shares tank, and you've promised to buy additional shares at the put strike price. It's a double whammy. So be sure to choose a stock on which you've done your homework. By the same token, avoid highfliers that are likely to surge past your written call strike. If you've found one, just be happy to hold the shares, and don't play around with writing calls to give away the upside. (For these sorts of stocks, buying calls on pullbacks is a better strategy.)

Remember, if your written put options are exercised, you'll have to buy more shares, which will double your position size in the underlying stock. Make sure you're comfortable with this allocation before writing a covered strangle.

The bottom line
You don't have to stand pat with a solid holding that is trading near its fair value. In many cases, you can squeeze out additional profits by writing covered strangles. With the risks accounted for, the strategy is a reasonably conservative way to take advantage of healthy stocks you think are likely to plod along. If you'd like to learn more about how you can use options to boost your returns, enter your email address in the box below to receive the Motley Fool Options "Options Edge" 2011 guidebook.