The Handy Tool That Protects Your Portfolio

Often with investing, you'll run across strategies that most people use for one purpose. Yet like medicines that turn out to have more than one beneficial use, some financial tools can play multiple roles in your portfolio.

One example of a multifaceted investment is the option. Commonly seen as a tool for speculators and other high-risk investors, options allow you to trade stocks with far greater leverage than you could obtain simply from buying and selling shares.

One strategy involving options, though, gets a lot of attention from those looking for extra income from their stocks. The covered-call strategy can help you earn more from your investments. Yet in addition to enhancing your payout, covered calls can also help lessen the blow from market downturns.

Using calls as protection
Typically, most investors don't think of call options as providing any downside protection. Buying put options lets you limit your losses, but most call options don't give you any guarantees against downward stock moves.

If you pick the right call option, however, you actually can get some portfolio protection. You just have to pick the right strike price -- the agreed-upon price to be paid for the underlying stock if the option is exercised.

A bird in hand, or two in the bush?
If you think your stock will rise and want to retain some of the upside, then writing calls with strike prices above the current share price makes sense. If you choose lower strike prices, though, you'll give up most or all of the upside -- but you'll get more compensation upfront for doing so.

For instance, take a look at some stocks where using a covered-call strategy might be appropriate:

Source: Yahoo Finance. As of Jan. 12 close.

Now compare two different covered calls on each of these stocks, one slightly above the market, the other slightly below:

Source: Prophet.net. As of Jan. 12 close.

Notice that in each case, you get significantly more in option premium from writing the low-strike call. That money is yours to keep no matter what happens to the stock. The trade-off is that if the stock rises and both calls get exercised, the low-strike option pays you less -- $50 per share rather than $60 in the Amazon case above.

What if the stock price stays the same? In the high-strike strategy, the option would expire worthless, and you would just keep the premium. For the low-strike strategy, however, the option would still have value. In each of these examples, however, you could buy it back at expiration and still have a profit over the high-strike strategy.

Meanwhile, if the stock falls, neither strategy will involve an option getting exercised. The extra premium will have helped you reduce your losses from the stock.

Does it make sense?
Of course, if you're willing to give up all the upside, why not just sell the stock? There are several possibilities. Capital gains taxes can play a role. High volatility levels give you more money from writing options. Or if you think a stock's upside will be suppressed only temporarily, you can pick your option expiration date to coincide with whatever catalyst you believe will make the stock move upward.

This low-strike covered-call strategy is just one example of how commonly used investing tools can serve many different purposes. Keep your mind open to potential multiple uses for such tools, and you'll enhance your investing technique and be able to capitalize on opportunities others miss out on.

For more on successful investing strategies, read about:

• Your best chance for big profits in 2009.
• Why the bear market may not have bottomed out yet.
• Is it time to get greedy?

In the new Motley Fool Pro real-money investment service, we're teaching about and using covered-call strategies. We're also building a long-term stock portfolio and using other option strategies for income and better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.