Profit As Stocks Go Nowhere

Following the market's record rebound from March 2009 to this spring, you shouldn't be surprised if stocks make like everyone's favorite 1970s toy and "sit and spin" for several months, if not longer. For equity investors, the wait for gains during churning markets can be tedious, if not demoralizing, especially since the past decade was already a wash for stocks. Very fortunately, some low-risk options strategies generate profits precisely when stocks go nowhere -- in fact, these strategies offer consistent profits in lame markets and lower risk than owning a stock alone.

After using options the past 10 years, one of my favorite strategies is called the covered strangle. This involves owning shares of a stock (usually one that pays a good dividend) and writing (or selling) options on it with strike prices above and below the current share price. This option strategy earns profits as long as the stock stays within a reasonable range.

If the stock goes up, you also profit on it; if it declines, your option income softens the fall, often leaving you with an overall profit. The only real catch is you need to be ready to sell your shares if they rise much, or buy more shares if the stock falls much. With that caveat in mind, writing covered strangles is an excellent income strategy for range-bound markets. It pays you income, offers upside, and plays defense, too. Let's look at some good examples.

Company

Share Price

Dividend Yield (Annual)

Strangle Yield

(Coming Months)

Western Union (NYSE: WU  ) $19.60 1.6%

10.4%

(Write November $19 puts and $20 calls, get paid a combined $2.05 per share)

Paychex (Nasdaq: PAYX  ) $29.85 4.1%

7%

(Write September $29 puts and $30 calls, get paid a combined $2.10 per share)

Intel (Nasdaq: INTC  ) $21.50 3.4% 10.1%
(Write October $21 puts and $22 calls, get paid a combined $2.18 per share)
American Express (NYSE: AXP  ) $47.50 1.5%

3.6%

(Write July $46 puts and $49 calls, get paid a combined $1.72 per share)

Data from Yahoo! Finance as of June 10.

Strangle quality stocks for profits
There are no fly-by-night operations here; these are all stocks a Fool should be happy to own. The companies offer decent dividends, but by writing strangles, a conservative investor can double or triple his or her income on these stock (or more), and earn it in a fraction of the time.

Payroll-processing leader Paychex has haunted the high $20s to mid-$30s for years, stuck in a range that leaves shareholders with little but the annual dividend. By purchasing half of a desired allocation in the stock (because the put options you write may require to buy another half later), and then writing a strangle that expires in just over three months, you could generate $2.10 in income for every share you own.

That represents a 7% yield on the stock you hold, and still about a 5% yield on the total equity or buying power you'll need to set aside to hold this trade open -- because when you write puts, you're obligated to buy the stock if it declines below your puts' strike price, so your broker will set aside cash for this potential obligation. Now, look at how this trade could play out in three months.

Action

Outcome

Buy 1/2 allocation in Paychex $29.85 per share
Write ("sell to open") September $29 puts Receive $1.00 per share
Write ("sell to open") September $30 calls Receive $1.10 per share
Net capital invested $27.75
   
Stock rises above $30 by expiration Shares are sold at $30, earning you an 8% profit in three months
Stock declines below $29 by expiration You buy your second half of shares at a net $26.90; your average all-in cost is $28.35; now write covered calls or wait for appreciation
Stock stays between $29 and $30 You earn the full $2.10 per share as the options expire, and can write a new strangle
Stock is between $27.75 and $32.10 You earn a partial to full profit on the options by expiration, and you can close the options early to end any stock obligations, and then write a new strangle

Since this strangle pays you $2.10 per share right off the bat, the stock can move 7% lower and you're still at breakeven. If the stock gains ground, you profit on the shares until your sell price and still keep the option income. If the stock stays in a smaller range than 7% in either direction, you earn all or some of the option income by expiration (depending on exactly where the stock trades), can end your strangle a few days early, keep the stock, and write a new strangle for more income. In other words, even when one of your strike prices is breached, usually you can close or adjust your trade before expiration and keep going for more income, rather than deal with a share trade. Strangles make it easier to adjust the trade, since one-half of the strangle is always earning its full profit.

True, if shares fall out of bed, you're obligated to fill out your allocation, but your second shares are bought at a considerably lower price of $26.90 per share, since you still keep your option income.

Writing covered strangles -- strategy summary: Own a half allocation in a stock; write ("sell to open") put options at lower strike prices, and covered calls at higher strike prices, to generate income on both sides of the share price.

Bottom line on strangles
Writing covered strangles is a flexible, powerful way to earn extra profits owning quality stocks. Imagine writing options to earn a 10% yield on your Intel shares between now and October, even while -- or especially while -- the stock goes almost nowhere? Options investors are doing this all the time, creating their own income for their portfolios. If this interests you, enter your email address in the box below to learn more about Motley Fool Options, which is opening to new members soon for a short period.

Jeff Fischer has a covered strangle on Western Union and American Express and owns shares of Intel. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Western Union, Intel, and Paychex, creating a write covered strangle position in Western Union, and creating a diagonal call position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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