Since its bottom on March 6, the S&P 500 has made a historic rally -- about 65% -- rivaling what we saw coming out of the Great Depression in 1938. However, if you take a gander at the years following 1938, you see -- after that big market rebound -- that stocks were relatively flat for a handful of years, including about 10% declines in both 1940 and 1941.
If you were an investor back then, you were left twiddling your thumbs, merely hoping for additional gains from the market at some point. These days, we're more fortunate. The market may end up being flat for a few years after its recent jump, but stock options, launched in the 1970s, give even a conservative investor ways to profit when a stock is flat.
The benefits of covered calls
The most common option strategy to profit if a stock stays flat, or goes down modestly, is also the most conservative: covered calls. When you write covered calls, you're selling an option contract that simply says: "I own at least 100 shares of this underlying stock. If the stock increases to my option's strike price by the option's expiration date, I'll sell you my shares at the option's strike price." In exchange for the contract, you get paid an option premium up front, and you keep that payment. This makes covered calls a popular income strategy. The risk is also modest.
For example, assume you own 100 shares of PepsiCo (NYSE:PEP), recently at $61.00, which you'd be willing to sell if the stock hit $67.50 by July 2010. You could write a call option contract (each one represents 100 shares of the underlying stock) with a strike price of $67.50, expiring July 16. Those options would recently pay you $1.50 per share, or a total of just more than $150. That money is delivered immediately to your account, and is yours to keep.
Let's see what might happen.
If PepsiCo doesn't reach $67.50 before mid-July, you keep your shares -- and you still keep the option income you were paid. This equates to earning an additional 2.4% yield ($1.50 divided by $61) on your stock in just seven months. And you can then write new covered calls for more income, if you'd like.
Conversely, if PepsiCo is above $67.50 by the expiration date, your shares are "called" away, sold from your account in July as the options are exercised. You're paid $67.50 per share for your PepsiCo, and you still keep what the options originally paid you, so your net sell price is actually $69. You've sold a bit higher than you actually wanted to -- great! Meanwhile, you were hedged a bit, with an extra $1.50 per share in protection the whole time.
Anyone can write covered calls, even in an IRA or tax-advantaged account. You just need to own at least 100 shares of the underlying stock, and can write one call contract for every 100 shares you own. If you're using the strategy on strong, stable businesses at good prices, one main risk is that the stock could soar away on you, since covered calls limit your upside to the strike price plus the option premium.
Strangle still more profits from a stock
For more experienced options investors, there's a way to essentially double your option income while writing covered calls on a stock. The assumption for this option strategy -- called a strangle -- is two-fold:
- You're willing to sell your existing shares if the stock rises above your desired sell price. So you write covered calls.
- You're willing to buy more shares if the stock falls below a certain desired buy price. So you write puts at the same time.
You're assuming a reasonable price range on a stock, and making money on both sides of it.
Let's assume you own 200 shares of UnitedHealth Group (NYSE:UNH), recently near $29 per share. You'd be willing to sell your shares by June if they're above $35, so you write two covered calls with a $35 strike price. Those calls recently paid $1.40 per share. Now, we also assume at the same time that you'd be willing to buy 200 more shares of UnitedHealth if it fell to $24 or below. So you also write (or "sell to open") two $24 puts that expire in June, paying you another $1.60 per share at recent prices. You've collected $3 per share total on your options, equating to a 10.3% yield, or payment, on the current stock price.
Now, if UnitedHealth is above $35 by expiration in June, your shares are called away at your $35 call strike price, but you've actually sold at $36.60 including what the options paid you. Conversely, if the stock declines below the $24 strike price of your puts, you get to buy 200 more shares at the strike price, but including the option premiums, you're actually only paying $22.40 per share.
Overall, the math here shows you that as long as UnitedHealth stays in a price range of between $22.40 and $36.60, you make money on this strategy and sacrifice little. The possible downsides are that if UnitedHealth goes above $36.60, you're missing additional upside, and if it goes below $22.40, the new shares you buy begin at a loss (and you'll need to wait for them to recover).
But the wide range for pure profit provided by the strangle, without needing to make any compromises, is sweet -- making this an especially strong strategy to use on blue-chip companies like UnitedHealth, Amgen (NASDAQ:AMGN), Merck (NYSE:MRK), and, moving away from health care, perhaps companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or American Express (NYSE:AXP).
Like what you own
The main thing to remember when writing covered calls or writing a covered strangle (which is what our second example is called) is to like what you own. If the stock you're writing calls or puts on falls sharply, you're stuck with it. But otherwise, writing covered calls and covered strangles are ways to juice returns on a flat stock or range-bound stock.
To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive information on Motley Fool Options, plus my free options guidebook.
