Squeeze More Income From Your Stocks

Options make it easy for aggressive investors to shoot for the moon with bold plays on their best investment ideas. But options aren't just for speculation. Many smart, risk-averse investors use options for a much less ambitious purpose: getting some more income from their investment portfolios. And the right options strategy can get you that income without a huge amount of risk.

Cover your calls
Although many people think that options are complicated, they don't have to be. At their core, options simply give you some additional choices to help you manage your investing risk at whatever level you feel comfortable. For instance, if you buy call options, you benefit from increases in a stock's price while limiting the maximum loss you can incur if the stock price drops.

An interesting thing about options is that you can sell options just as easily as you can buy them. In fact, most brokers will let you sell call options without having previously purchased them, as long as you own shares of the underlying stock on which the option is based. Selling calls you don't own may sound like selling stock short, which can be extremely risky. But when you own the underlying stock as well, you change a potentially risky strategy into a relatively safe one, known as the covered call strategy.

Here's how covered calls work. For every 100 shares of stock you own, you sell one call option contract. The option you sell gives the investor who buys it from you the right to buy your shares at the specified strike price at any time before the expiration date you choose. If the option buyer chooses to exercise the option, you're required to sell your shares at the agreed-upon price. On the other hand, if the option expires without the buyer having chosen to exercise it, then you get to keep your shares -- along with the option premium that the buyer paid you up front.

Get paid to invest
The fact that other investors are willing to pay you to buy a call option is the key to generating more income from your stock portfolio. Covered calls can both turn non-dividend stocks into income payers as well as boosting the effective yields on dividend stocks.

Taking the first category, let's look at the three biggest non-dividend-paying stocks in the S&P 500:

Stock

Current Price

Call Option

Option Price

Effective Yield

Apple (Nasdaq: AAPL  ) $355.76 April $375 $4.20 1.2%
Google (Nasdaq: GOOG  ) $592.31 April $625 $8.30 1.4%
Berkshire Hathaway (NYSE: BRK-B  ) $86.35 April $90 $0.61 0.7%

Source: Yahoo! Finance. Prices as of March 8.

Yields around 1% may not seem all that substantial, even with current low interest rates. But remember, those yields are for options that expire in just over a month. As long as your shares aren't called away, then you can repeat the process by selling more options in the future, reaping that 1% over and over again.

Conversely, if you use the strategy on stocks that already pay a dividend, you can get more income. Consider the four largest dividend payers in the S&P 500.

Stock

Current Price

Call Option

Option Price

Effective Yield*

ExxonMobil (NYSE: XOM  ) $84.60 Jan. 2012 $90 $3.90 6.7%
General Electric (NYSE: GE  ) $20.63 Jan. 2012 $25 $0.52 5.2%
Chevron (NYSE: CVX  ) $103.77 Jan. 2012 $120 $2.50 5.2%
IBM (NYSE: IBM  ) $162.28 Jan. 2012 $180 $4.75 4.5%

Source: Yahoo! Finance. *Effective yield = annual dividend plus option price, all divided by current stock price. Prices as of March 8.

Each of these stocks already carries a dividend yield of 1.5% or more. But by choosing options that don't expire until next January, you get more when you sell a call option. The resulting boost in income greatly increases the total effective yield.

The one thing you give up with the covered call strategy is the chance to reap big profits if the price of your stock rockets upward. If shares rise beyond the strike price by the time the option expires, then your shares will get called away, and you'll receive less than you could get by selling on the open market. But since you choose the strike price of the option up front, you can control how much upside potential you give up.

Take cover
The covered call strategy is a great way to produce income in a challenging environment for income investors. But when it comes to options strategies, call options are only half the story. Tomorrow, we'll turn to the dark side to take a look at how you can use put options can protect your portfolio.

To learn even more about options, be sure to check out our Options Center. You'll find a tutorial on options and much more.

Fool contributor Dan Caplinger covers his bases. He owns shares of Berkshire Hathaway. Berkshire Hathaway and Google are Motley Fool Inside Value recommendations. Google is a Motley Fool Rule Breakers selection. Apple and Berkshire Hathaway are Motley Fool Stock Advisor picks. Chevron is a Motley Fool Income Investor recommendation. The Fool has written puts on Apple, on which Motley Fool Options has recommended a bull call spread position. The Fool owns shares of Apple, Berkshire Hathaway, ExxonMobil, Google, and IBM. Try any of our Foolish newsletter services free for 30 days. 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's disclosure policy gives you all the options.


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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 March 10, 2011, at 9:09 PM, investor7957 wrote:

    Hello

    How do you screen stocks for option trading ?. Are those 3 just off the cuff suggestions or do you use any specific screening methods to pick the right stock for option trading?.

    Thanks

    Tom

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