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The new year is the traditional time to make resolutions on things we'd like to do better. And unless you're one of Warren Buffett's superinvestors who have already mastered the stock market, you may find that you have room for a resolution or two for improving your investment strategy.
Unfortunately, resolutions are notoriously hard to keep. If they weren't, we'd all be rich, thin, non-smoking marathon racers. But what if there were a way to get paid to keep your resolutions? Wouldn't that help motivate you, at least a little bit?
Fortunately, there often are ways to get paid from your investments, regardless of whether you're resolving to improve your ability to buy, sell, hold, or sock away more. This is the fourth and final in a short series on how to do just that, and it focuses on how to get paid a bit more to sell your stocks.
Why selling matters
The discipline to sell is one of the toughest for many investors -- myself included -- to master. Greed makes it difficult to sell a rising stock, because it's easy to want to hold on for "just a little bit more," only to see the stock later drop and those highs not return for a good long time.
In 2011, I fell for that myself, holding on to shares of air conditioning titan Lennox International (NYSE: LII ) as its shares passed $50. I had pegged the stock's value closer to $40, as I wasn't sold on the potential of a housing recovery in 2011 that was being pitched at the beginning of the year. Yet the only way I could get a value in line with the stock's then market price was by assuming a healthy housing rebound.
The then-current price represented a nice premium to the stock's true value, and I knew I should have simply pulled the trigger and sold my shares. Unfortunately, greed got the better of me, and I held out, hoping for $55. So rather than the $50+ I could have received, I held on to hope as the company reported disappointing second-quarter earnings, driven in part by poor housing numbers. And in an instant, the premium price that I could have captured (and then some) was gone.
Enter call options
With better discipline, I would have made the sell decision based on valuation and stuck with it. Yet that discipline proved elusive. Fortunately, with an incentive attached to being disciplined, it's much easier to accomplish. In this case, the available incentive comes in the form of the time value premium from writing a covered call.
To make it work, all you need is at least 100 shares of a given stock and the right to write covered call options on your brokerage account. A call option gives the buyer the right to buy -- and the seller the obligation to sell -- a given stock at a given price on or before a certain date.
By selling covered calls on the stocks you own at strike prices at which you'd be willing to part with them, you can get paid a premium now to sell your stock later at a price you're willing to sell at anyway. Sure, the premium is typically only a few percent, but it does enable you to get paid to keep that otherwise elusive sell discipline.
For instance, right now, I have an open March 2012 covered call position on Select Comfort (Nasdaq: SCSS ) , at a strike price of $22.50. I've long thought that the company operates in a cyclical industry, yet it occasionally gets priced as if it could outgrow such a notion. With a cyclical view on its earnings forecast, I estimate a value around $20 a share, and I should happily accept $22.50 as a 15% premium to that level.
Now that the shares have topped it, I'm at risk of being required to sell at $22.50. Yet with the $1.50 a share (before commissions) I got for selling those calls, my effective sale price would be about $24. Not a bad trade-off for shares I value around $20, and it's essentially like getting paid to maintain the selling discipline I was otherwise lacking.
For a while, I also had a covered call option position open on Discover Financial (NYSE: DFS ) at a $28 strike price. That's a 12% premium to the $25 I had estimated as the company's fair value, thanks to the then improving credit conditions within the economy.
I'm still willing to part with those shares at $28, but Mr. Market gave me the opportunity to buy back the calls for a nickel that I had sold for $1.25. With the time value on those options down to virtually nothing with what was then a month prior to expiration, I couldn't pass up the opportunity to close that option position and look for the potential to open another, to capture more time value.
The big risk
Of course, there's no such thing as a free lunch, and that includes covered calls. One of the biggest risks is that you do miss out if a stock you own takes off between the time you sell the call and the time the option expires.
That happened to my wife, with her shares in clothing retailer Limited (NYSE: LTD ) . Its business (and share price) recovered faster from the economic doldrums than we had thought it would when she sold the calls. While she captured both her option premium and a decent gain on the shares, she could have gotten significantly more had she better projected the company's recovery.
It's because of that risk that you need to get a decent premium for your call if you're willing to sell, because the commissions could otherwise eat up your potential benefit if the call is exercised. Still, if your investing resolutions include a desire to sell when you know you should, selling covered calls is a great way to get paid to enforce that discipline. If, like mine, your portfolio is chock-full of stocks that you wish you would have sold when you had the chance, it's a resolution worth being paid to keep.
Making resolutions like this is a great way to get started on a complete financial makeover. But you also need a big-picture view. Take a look at the Fool's latest special report, "The Shocking Can't-Miss Truth About Your Retirement." It has plenty of insight on preparing for the long haul with your money. It's free, but available only for a limited time, so click here and grab your copy today.