How to Create Big Income on Go-Nowhere Stocks

You've undoubtedly heard the old adage that a great company doesn't necessarily make a great stock investment.

That's because valuation and forward prospects matter. Big, stable, blue-chip companies are widely followed, their prospects are well-known, their stock prices generally reflect the available information on the company, and they're generally so big, their explosive growth periods are well in their past. In short, they're not going to run away on you.

One options strategy you can use to earn income on a slow-moving stock is known as a diagonal spread. It works something like a covered call -- except that, instead of making a pricey upfront investment in shares of a stock and selling call options against them, you replace the stock purchase with a cheaper long-term call option. Let me walk you through an example or two:

First, find a great company
Some candidates you might consider are Intel (Nasdaq: INTC  ) , which has spent most of the last decade bouncing between $17 and $28, or Home Depot (NYSE: HD  ) , which today sits below its price of 10 years ago despite tripling its revenue in that span and nearly doubling earnings per share.

A personal favorite is online auctioneer and electronic payment facilitator (by way of its PayPal subsidiary) eBay (Nasdaq: EBAY  ) , a global powerhouse that gushes cash.  Yet long-term returns have been mundane. The 10-year annualized return on the stock alone is 5.8%. I believe diagonal calls can offer even more.


Choosing your diagonal options

A diagonal has two components: a purchased lower-strike call that expires as far in the future as possible, and a written higher-strike call that expires in the short term. Generally speaking, you want to implement the strategy on a good name trading at a "fair" valuation. You then want to buy as long-term a call as possible, with minimal "time value" -- that is, the difference between the current stock price and the call's strike price. When in doubt, it's often worth it to be a little defensive with your owned call selection and pay up for a strike price well below the current stock price.

Let's say that I believe PepsiCo (NYSE: PEP  ) is fairly valued today around $67 to $70. With Pepsi recently selling for $69.51, the January 2013 $55 calls selling at $15.25 offer a reasonable balance between minimal time value paid and cash out of pocket. On the short-term written call side, we typically look about three months out, with a strike price marginally above the current stock price. Writing the October 2011 $72.50 calls pays us $1.06 per share.

Now, step back and consider your combined position. We've gained exposure to the underlying stock via our long-term call option for considerably less cash than buying the stock outright. If the stock price rises, it will pull the value of our owned calls up with it. Options aren't entitled to dividends (Pepsi pays $0.515 quarterly), but our written short-term, higher-strike call offers us far more. Even accounting for differing tax rates on dividends and written calls, the total return on the diagonal trumps straight-up stock ownership for a slow/no moving stock. Here's the comparison if the stock hits the $72.50 strike at October 2011 expiration:

 

Stock Ownership

Diagonal

Buy underlying stock or long-term call option $69.51 $15.25
Cash received (dividend or written call premium) $0.515 $1.06
Total profit – stock at $72.50 at expiration $3.51 $3.06
After-tax total return 3.4% 14%

Come October, if PepsiCo's stock price is at or below the short-term call's $72.50 strike, that option simply expires worthless, and we retain the still-valuable January 2013 $55 calls. Rather than closing the position, it's a matter of lather, rinse, and repeat: We'd simply write another call with a strike that's similarly above the current stock price. Conversely, if the stock runs above the short-term call strike, the value of the January 2013 call you bought will go up as well. In a worst-case scenario, you can sell the owned long-term call and use some of the proceeds to buy back the previously written call -- and your gains should still be ahead of stock ownership plus dividends.


What can go wrong
Be aware of ex-dividend dates. If the stock price is higher than the short-term call strike, and the dividend payment exceeds the remaining time value the day before the stock goes ex-dividend, your short-term call could be exercised against you, leaving you short in the stock. In that case, you then are responsible to pay the dividend to the opportunist who bought the calls you wrote.

Also, choose your underlying stock wisely. A rip-roaring momentum name like salesforce.com (NYSE: CRM  ) or a consistently performing growth engine like Apple (Nasdaq: AAPL  ) are not good candidates for diagonalization. For these sorts of stocks, buying calls on dips makes more sense. With diagonals, big and boring are your friends. And finally, be aware of the stock price -- if it falls below the long-term strike price, re-evaluate your trade posthaste -- and of taxable transactions. (Consult your tax pro if necessary.)


The Foolish bottom line
Diagonals aren't for everyone, and they take some vigilance. But they can be a worthy tool to enhance your investment income. If you'd like to find out more about how you can use options to boost your returns, simply enter your email address in the box below to receive Motley Fool Options' "Options Edge" 2011 guidebook.

Jim Gillies has no positions in any company mentioned. The Motley Fool owns shares of Apple and PepsiCo. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Apple, salesforce.com, eBay, Home Depot, PepsiCo, and Intel. Motley Fool newsletter services have recommended creating a diagonal call position in Intel and PepsiCo and a bull call spread position in Apple, as well as shorting salesforce.com. 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 Motley Fool has a disclosure policy.


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