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The Simple Strategy That Beat the Market

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Last year's stock market was a disappointment to nearly everyone. With a flat performance for the S&P 500 index, neither index investors nor short-sellers made any money, adding to the sense that the entire 21st century has been a terrible environment for shareholders.

But by using a strategy that embraces the market's flatness rather than cursing it, some investors are finding rewards even while stocks stand still. But can you use this strategy now -- or will those who rely on past performance for future results end up getting burned?

Later in this article, we'll take a look at some stocks that are smart candidates for investors interested in profiting from a flat market. But first, let's take a look at the strategy itself and see how you could use it to your advantage.

Call me
Upfront, a warning: This strategy involves options. But even if options scare you to death, don't stop reading. Unlike many options strategies you've probably heard about in the past, this one doesn't boost your risk -- it reduces your risk. Specifically, using it can lead to two possible outcomes:

  • If the stock you own doesn't do well, then the strategy helps you reduce your losses somewhat.
  • If the stock does well, you're guaranteed a profit -- and as long as the stock doesn't do too well, that profit will be bigger than it would've been without the strategy.

What I'm talking about here is known as a covered call strategy. To use it, all you have to do is write call option contracts against stock that you already own or that you choose to buy. By doing so, you're immediately giving the investor who buys your option the right to buy your shares from you at a set price -- typically one that's higher than the current share price. In exchange, you receive an option premium -- a fixed payment that's yours to keep no matter what happens.

If the stock falls or goes up to less than the agreed-upon strike price of the option, then the option buyer won't exercise the option, and you'll get to keep both your shares and the premium you received. If the stock soars, though, you'll have to sell your shares to the option buyer, thereby missing out on a portion of the profits you would've earned simply by holding the stock.

Why covered calls?
An article in Barron's over the weekend talked about a study that Goldman Sachs released recently. The study looked at using covered calls over a period of time and concluded that a typical user of the strategy would have seen 6% to 8% returns last year, in the flat market.

Goldman says that by timing the strategy to use it on especially volatile stocks in months without earnings releases, portfolio returns rose by more than 5 percentage points annually from 1996 to 2011.

Which stocks are smart?
Covered calls work better on some stocks than others. PepsiCo (NYSE: PEP  ) has plenty of growth opportunities in its soft drink and snack businesses, but while its stock has made solid gains in recent years, it has tended to stay in a fairly tight range. That means option-writers won't get as high a premium on covered calls, but the stock's high dividend further rewards your patience.

You can see a similar pattern with Yum! Brands (NYSE: YUM  ) , which has the same exposure to emerging-market growth despite slow U.S. sales. With higher gains, though, a Yum!-based covered call strategy likely would have forced you to sell shares at some point -- and if you hadn't bought them back, you would've missed out on future profits as the company's expansion continued.

Yet the Goldman experience suggests looking even at more volatile stocks. Apple (Nasdaq: AAPL  ) tends to be extremely volatile when it announces earnings, as investors have seen recently. But look between earnings and you'll see somewhat fewer pops and a bit more stability -- helping option-writers profit.

Still, some stocks are too volatile for covered calls to reduce risk. Dendreon (Nasdaq: DNDN  ) , for instance, rises and falls at unpredictable intervals as information about its Provenge cancer drug comes in. Similarly, a covered-call strategy on Arena Pharmaceuticals (Nasdaq: ARNA  ) , which faces the win-or-go-home decision on its obesity drug in the next year or so, could take away most of your upside while leaving you with all the downside. That's obviously not a path to profits.

Consider all your options
Covered call writing isn't for everyone, and while it works well in flat markets, it doesn't always boost returns in other market environments. But it's a useful weapon to add to your investing arsenal that can turn no income into enough income to get by.

Over the long haul, the right stocks can mean the difference between retiring rich and working longer than you want. The Motley Fool's latest special report looks at several stocks that have the features you need to have a rich retirement. It doesn't cost a dime -- but grab it today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger keeps all his options open. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Yum! Brands, Dendreon, PepsiCo, and Apple. Motley Fool newsletter services have recommended buying shares of Yum! Brands, Apple, and PepsiCo, as well as creating a diagonal call position in PepsiCo and a bull call spread position in Apple. 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 is never optional.

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