One Strategy You Should Be Using in This Market

Now's the time to prepare for a flat market.

On Friday, the government announced that in November unemployment rate fell -- that's right, fell -- unexpectedly from 10.2% to 10.0%. After two years of job cuts, one might expect the market to rejoice and begin a new rally. Unfortunately, the market barely budged on this better-than-expected news.

How can this be? It's the same reason the market shrugged off the spike in unemployment from 9.8% in September to 10.2% in October: The market is forward-looking and had already priced in expectations of economic improvements months ago. That's why it rallied 60% off the March lows. Better-than-expected reports are simply confirming that thesis.

Since the expectations of good news are already largely priced in, I find it unlikely that the market has much more room to run on the upside over the next few months. At the same time, however, because so many retail investors have bailed on equities and into fixed income over the past year, I don't think it has a lot of room to fall, either.

A market with no direction -- a market like this one seems to be -- is the perfect time to reap profits by selling covered strangles.

Strangle that market
When you sell ("write") a covered strangle (also called a short strangle), your goal is to profit on a stock you already own and are willing to buy more of at a lower price, but are also content with selling at a slightly higher price than it's currently selling for.

The best way to explain an options strategy like the covered strangle is to illustrate it first and work backwards, so let's say you just bought 100 shares of XYZ Holding Company, which is currently trading around $14 a share. You'd be happy to buy more of the stock below $13, but you'd also be content with selling it around $15. To enter a covered strangle trade, you would simultaneously:

1. Sell one $15 call option expiring in four months for $1 per share premium (each option represents 100 shares of the underlying stock, so $100 per contract).
2. Sell one $13 put option expiring in four months for a $1 per share premium.

Here are the three potential outcomes:

It's an intriguing strategy because rather than be captive to the market's placidity, you can generate income from your existing positions and reload your cash position while you wait for the market's next move.

OK, but what are the risks here?
The two primary risks of this strategy are:

1. Forgoing upside potential: If XYZ Holding soared to $30 a share before expiration, you would still have to sell at $17 and would miss out on that extra appreciation.
2. Buying before a plunge: If XYZ Holding plunged to $5 a share before expiration, you would still have to buy 100 more shares at $11. In this case, you would have been better off waiting to buy more shares.

These risks may be off-putting at first, but the key to managing the risks is a thorough understanding of the stock on which you're writing the covered strangle.

Options are derivatives, of course, meaning they derive their value from the price movements of the underlying stock, so it stands to reason that if you know the company well and have a good grasp of what its fair value should be, you can greatly reduce your chances of being wrong with covered strangles.

Finding some candidates
Good candidates for covered strangles, then, will be stocks of strong companies that are not wildly overvalued (lest they drop sharply) nor grossly undervalued (lest they surge).

Fortunately, if you think the market rally has stalled, then there are plenty of great companies out there you could consider writing covered strangles on today. Here are five candidates:

 *Data provided by Yahoo! Finance, as of Dec. 7, 2009.

These are all strong companies that, compared to the market's average forward P/E of 16, appear neither wildly overvalued nor grossly undervalued. Whether you already own shares in these companies or want to start a position in them today, you should consider the covered strangle strategy.

You can also use the covered strangle strategy on any ETF that has options, like SPDR Gold Shares (NYSE:GLD) or PowerShares DB Agriculture Fund (NYSE:DBA), though I encourage you to understand what those ETFs hold before considering such an investment.

Foolish bottom line
If we're in store for a flat market in the coming months, writing covered strangles is a great way to generate income while the market's not doing much of anything. I cannot caution you enough, however, on two things:

1. Be sure you own round lots of 100 shares before writing the calls, otherwise you'll have a "naked" call on your hands. In that case, the risk profile of the strategy changes dramatically, and your losses are potentially unlimited if the stock soars.
2. Be sure you want to own more shares of the stock or ETF at a lower price before writing puts. The last thing you want is to buy a stock you didn't want to own at too high a price.  

At the end of the day, this strategy works best when you have deep understanding of the underlying companies and are comfortable with the risks. That's why our Motley Fool Options service recommends options trades on the best stock ideas across other Motley Fool newsletters.

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