Be Smart About Options

Many investors steer clear of options. But under the right circumstances, even ordinary investors can take advantage of options to generate more income from their stock portfolios.

As Foolish options expert Jeff Fischer has explained before, a covered call strategy can turn even stocks with flat performance into money-making investments. But options are far from fail-safe, so you want to make sure you pick the right ones. How you do that can make all the difference to your performance.

4 tips for covered calls
I prefer a conservative approach with covered calls. It's too easy to find some option screener for high premiums, get greedy, and sell calls against a stock you know nothing about. So I have a specific set of criteria for when covered calls are a good option (pun fully intended). Here it is.

1. Start with a stock you know well that you own or want to own. Before I use a covered call strategy on a particular stock, I prefer to track that stock's price movements for months, if not years. Some stocks exhibit trading patterns or remain range-bound for long periods of time, which can make covered calls especially lucrative.

For example, since early 2007, shares of EZCorp (NASDAQ:EZPW) have stayed in a relatively tight trading range. This allowed me to write one-month calls over and over again. Even though the stock stayed pretty flat for the first 21 months of this period, I captured a 55% return just by selling calls.

The company has to be one that I own, because buying the underlying security and selling calls against it without knowing anything about the company is just gambling. If you buy that security and the stock suddenly falls big time, what seemed like a nice return for a short holding period will be small consolation.

Case in point: I purchased shares of Research In Motion (NASDAQ:RIMM) back in early 2000 for the purpose of collecting a huge call premium. The stock had soared into triple digits, which meant a double-digit call premium. I collected it ... and the stock gradually fell over 50%, creating a substantial loss in a stock I really didn't want to own.

However, falling shares isn't always a problem. As long as I want to own the stock anyway, then what I collect from writing the call option is just a bonus -- unless some catastrophic, game-changing news is behind the stock's decline.

And should my shares get called away, but the stock price on options expiration day still be below the strike price plus option premium I collected, I would just buy the shares back.

2. Pick stocks that aren't likely to see huge moves from market-moving news items. In my view, stocks with potentially market-moving exposure, such as huge pending litigation or regulatory issues, aren't good candidates for covered calls. On the occasions when I purchase a stock with this type of risk in the first place, I typically want to participate in the full upside potential if things go right, rather than having my stock called away for a smaller profit.

Similarly, I tend to pick stocks that are in between their quarterly earnings reports. I don't want my stock to get called away on a positive earnings surprise.

3. Sell calls against only half of your position. I want my stock to go up over time. If I'm selling a call, it's because I think it's going to stay relatively flat rather than moving up sharply. Still, if the stock suddenly rockets, I don't want to feel like an idiot for having sold calls against my entire position.

4. Have a return target and minimize trading costs. Sell calls in bulk to minimize fee impact, and collect a 2.5% minimum monthly return. It's important to have a profit target for a covered-call strategy. Personally, I aim for a monthly return of 2.5%. But your number might be different depending on your risk tolerance and the types of stocks you prefer.

Moreover, in order to minimize the commissions I'm paying, I try to sell calls in bulk. That way, I pay a smaller percentage of a given trade in commissions.

Putting it all together
Let me share some stocks that I'm familiar with that I believe fit most of the criteria above fairly well:

Source: Yahoo! Finance.

It may sound like a lot of work, but the truth is that if you are investing in a company, you probably already know a lot about the stock's behavior anyway. You might want to have slightly different standards from mine, but the important thing is to have some set of criteria. By keeping those criteria foremost in your mind, you'll find the best opportunities to enhance returns.

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Interested in options? Read more here, if you dare:

• Options? Are you Nuts?!
• One Way to Bet Against the Market
• How to Repair a Broken Stock