Make Money in Technology -- It's Your Call

Picking stocks is hard. Statistically speaking, the deck is stacked against anyone who tries. I'll tell you why in the next section, but first, I want to reassure you that investing isn't a loser's game. You can still win, as long as you consider all of your options.

One strategy can help tip the scales back in your favor: writing covered calls. This isn't wizardry, or the sort of tactic employed by shouting traders in an options pit. You can use this easy-to-master tool in conjunction with healthy, well-run, fairly valued stocks -- the kind that aren't prone to blowups or other damaging disasters.

You probably won't pick a winner
Eric Crittendon, director of research at hedge fund Blackstar Funds, conducted a study revealing that 25% of stocks provide all of the market's gains. Effectively, 75% of stocks work against your quest for returns. Viewed another way, Crittendon shows that one in five stocks is a significant winner, but the same proportion are significant losers. That means we're equally likely to choose a big loser as we are a big winner.

The middle of the pack, meanwhile, does nothing. We've got a 60% chance of picking a stock in that category. This means that almost 80% of the time, a stock we pick will be a dud or a detractor. Those odds aren't good.

Covered call writing allows us to boost the returns of the middle 60% of stocks -- the ones we're statistically most likely to pick.

How covered call writing works
A covered call simply combines two investments: a block of 100 shares of stock, and a written call option on the same stock. When we introduce the call option to share ownership, it changes the risk and reward profile of our position. When you own a stock, your risk is the price you paid for the stock -- after all, it could go to zero. Your reward is the stock's gain. When you write a covered call, your downside risk is offset slightly by the option premium you're paid. In exchange for that premium payment, you agree to forgo the stock's upside beyond its strike price. (If the stock rises that far, the call will be exercised, and you'll have to sell.)

Normally, agreeing to forgo that upside in exchange for a small up-front payment wouldn't seem like a great idea. But when you couple the strategy with Crittendon's research (namely, our 60% chance of picking a dud stock), it doesn't seem so crazy. And since we can write covered calls that expire at three-to-four-month intervals, we can collect a series of premium payments over the course of a year. These payments, along with dividend payments and the mild stock appreciation we allow ourselves by writing out-of-the-money calls, can make a covered call option strategy a conservative and consistent way to boost returns.

What to look for in a call candidate
Remember, writing covered calls involves owning 100-share blocks of stock. First and foremost, you need to find a stock with a decent business and solid financial footing.

Next, you should look for "fair value." Given that stock valuation is more art than science, seek candidates that seem priced about right -- given market efficiency, that's most stocks -- or have mild upside. You don't want wildly underpriced stocks; if you find one along the way, just buy it outright, rather than missing out on its upside.

In the tech sector, many stocks fit this bill. Here are some healthy, fairly valued, and profitable covered call candidates:

Company

Debt-to-Capital

Forward P/E Ratio

Operating Margin

Akamai Technologies (Nasdaq: AKAM  )

0%

23

26%

Broadcom (Nasdaq: BRCM  )

11%

15

15%

Hewlett-Packard (NYSE: HPQ  )

33%

8

11%

Logitech International (Nasdaq: LOGI  )

0%

23

7%

Novell (Nasdaq: NOVL  )

0%

24

11%

Qualcomm (Nasdaq: QCOM  )

5%

19

31%

Texas Instruments (NYSE: TXN  )

0%

14

32%

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

A tech covered call you can write today
Of the candidates above, Logitech sticks out as a great possibility for writing covered calls. In its current form, Logitech earns the bulk of its cash from selling mice (the computer kind, not the squeaky kind), keyboards, and audio/video devices. These products provide a solid stream of cash to support the launch of new products that augment the smartphone, tablet, and living-room user experience. But competition is fierce, shares trade at 23 times estimated 2011 earnings, and management has a history of issuing a slew of stock options that eat into cash available to shareholders. All of those facts lead me to believe that Logitech, which I think is worth somewhere around $21 per share, appears fairly valued, with moderate downside risk.

Purchasing shares today at $19.54, and writing June $21 call options, will pay you $0.80 in option premiums. With just more than 100 days until expiration, you can earn $1.46 in share appreciation and $0.80 in option premium if Logitech shares rise to what I think they are worth. That amounts to a 12% return if exercised -- and the $0.80 in option premium you're paid acts as downside protection, because you won't lose money unless Logitech shares drop more than 4%.

The bottom line
Crittendon's research implies that finding solid businesses on firm financial footing won't necessarily translate into successful investing. But investors who embrace most stocks' middling performers and willing to augment returns with the use of a covered call strategy, winning investment returns are just a step away. To learn more about the profitable options strategies we've been using in our portfolios for years, simply enter your email address in the box below to receive information on Motley Fool Options and get a copy of our free "Options Edge" guidebook.

Bryan Hinmon doesn't own any shares mentioned in this article. He is an analyst with Motley Fool Options. The Motley Fool owns shares of Logitech, Qualcomm, and Texas Instruments. Akamai is a Motley Fool Rule Breakers recommendation. Logitech is a Motley Fool Hidden Gems recommendation. 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.


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