I have a hard time seeing pharmaceutical companies increasing in value that much in the next year or two. Between the loss of sales because of generic competition and lackluster pipelines that will be lucky to replace those sales, there just isn't much of a catalyst for them.

But that doesn't necessarily mean that large drug companies will make horrible investments, either. They're fairly stable, so the downside risk is minimal, and investors get paid a decent dividend to wait for better times.

Company

Dividend Yield (TTM
unless otherwise noted)

Pfizer (NYSE:PFE)

3.9%*

Johnson & Johnson (NYSE:JNJ)

3.0%

Merck (NYSE:MRK)

4.1%

Eli Lilly (NYSE:LLY)

5.4%

Bristol-Myers Squibb (NYSE:BMY)

5.0%*

GlaxoSmithKline (NYSE:GSK)

4.4%

Novartis (NYSE:NVS)

3.1%

Source: Yahoo! Finance. TTM = Trailing 12 months.

*Annualized based on recently announced dividend.

Juicing up those yields
If the companies stay flat over the next year or two, that's not a particularly great return. But that kind of environment is perfect for selling covered calls to increase the income you receive from owning the shares.

Sellers of call options are obligated to sell 100 shares per option at an agreed-upon price -- called the strike price -- should the buyer of the call exercise the option. If the stock price is below the strike price when the option expires, the buyer won't exercise, but you still get to keep the money you received when you originally sold the call.

As an example, here are recent prices for Pfizer's calls:

Call Strike / Expiration

Recent Quote for Call (per share)

Annualized Return From Selling the Call

Potential Annualized Return If Exercised (excluding dividend)

$19 / Feb. 19, 2010

$0.45

17.4%

36.8%

$20 / Feb. 19, 2010

$0.20

7.7%

65.8%

$20 / June 18, 2010

$0.65

7.5%

25%

$22.50 / June 18, 2010

$0.17

2%

48.4%

Source: Yahoo! Finance. Based on closing price for Pfizer stock and options on Dec. 30. Annualized returns based on simple interest calculation. Potential return if exercised includes stock appreciation.

Now we're talking. Depending on where you think Pfizer might end up in February, June, or the myriad other expiration dates available, you can select a return that's appealing. Keep in mind, though, that the $0.45 for the February $19 call only represents about a 2.4% boost to your return -- you'd have to write similar calls throughout the year to earn an actual return close to the 17.4% figure listed.

Some caveats
There's no such thing as a free lunch. The reason someone would be willing to pay you for the option of buying your shares in the future is that they get to take advantage of any and all of the price increase above the strike price while your return is capped. If a stock gets bought out at a premium or its price skyrockets for any reason, then you would be stuck with selling your shares at the strike price. And although the table above shows that you'd get a good return if that happened, you'd miss out on gains that could be much larger.

Transaction costs killed the good intention. Unlike dividends that just show up in your account, selling calls incurs broker fees and, depending on the broker, additional costs if the options are exercised. You may need a large holding to justify the transaction costs, especially if you're going to try to sell calls every month or two.

Don't let your call get naked. If you've sold a covered call and want to sell the underlying stock, you'll want to pay to close the call as well so you no longer have the obligation to sell a stock you don't own. Leaving them uncovered is dangerous because, like shorting a stock, a naked call has unlimited downside potential. Closing the call is not a major issue, but it'll cut into your returns.

What's yours is mine. Remember those dividends? The ones I started the article with as a reason to justify owning large drug companies in the near term? They're yours as long as you own the stock, even if you've sold a covered call, but the owner of the call can exercise early in order to get the dividend. It won't happen that often, but keep it in mind when calculating potential returns.

Not your parents' dividends
Just like chasing high yields can be dangerous, chasing covered call income can be just as stupid. It's no help to make 10% on covered calls if the underlying stock you own drops by 10%. The best approach is to look for companies that you're comfortable owning and then see if the covered calls pay well enough to justify selling them. Looking the other way around is a recipe for disaster.

Have any suggestions for covered call candidates? Share them in the comments box below.

Johnson & Johnson is a Motley Fool Income Investor recommendation. To see how dividend-paying stocks can offer both secure income and the opportunity for growth, take a free look at the newsletter with a 30-day trial.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Pfizer is a recommendation of the Inside Value newsletter and Novartis is a Global Gains selection. The Fool owns shares of GlaxoSmithKline and has a disclosure policy that pays a dividend daily.