A Long-Term Investor's Approach to Big Profits

Covered calls are a popular, and deceptively simple, option strategy. Done correctly, you can generate income on a stock you own -- and do so over and over again to keep the cash flowing.

Call of the wild
A call is the right to buy a stock at a pre-set strike price. For a covered call, you actually sell the call option on a stock either already owned or that you have purchased with the intent of implementing a covered call. The call buyer pays you for the right to purchase your stock if it hits the strike price by the time the option expires.

Selling calls against your stock immediately changes your stance from unabashedly bullish (stock, go up now), to a neutral yield play. If you're selling the upside of a stock, do so on a stock you believe to have minimal upside. The path to covered call master is littered with retail investors lamenting about writing calls against a high-flyer like Netflix (Nasdaq: NFLX) or salesforce.com (NYSE: CRM). For these sorts of stocks, buying calls is usually a more appropriate strategy.

Put simply, only use this strategy on stocks that you believe to be reasonably and conservatively fairly valued. Writing calls on undervalued stocks gives away potential upside gains. Writing calls against overvalued stocks is dangerous as any drop in stock price could easily surpass the cash received for writing the call. But if the stock is fairly valued, and you're OK with selling your shares at the strike price, covered calls are an excellent way to leverage your returns over the long term.

Over the long term?
Even though options have finite lives, an options strategy doesn't have to. I approach covered calls as a long-tailed series of cash flows. I generally target a rate of return from 15% to 25% annually for a series of covered calls on the same stock.

To share a personal example, I've employed this strategy on Buffalo Wild Wings (Nasdaq: BWLD) for over three years. (I hold these shares in a tax-sheltered account, so I'm not losing a chunk of my gains to the taxman). This table shows my transaction series.

After setting up the position on a day when B-Wild released a disappointing quarter, the stock continued to fall, and my initial March 2008 calls expired. Yet B-Wild stuck to its knitting, opened new stores, increased profits, and generated cash -- and my valuation estimate crept into the low $40s. By autumn 2008, the stock again hit $40, and I resumed writing calls.

Then the credit-crunch-induced market panic took the stock down to the mid-teens. Again, at a price far below my estimated value, I was content to wait uncovered. Fear subsided, and the stock rebounded, eventually reaching the $40s again in April 2009, and I refired my call-writing engine and have kept it fueled ever since.

Since starting this little exercise, the market has fallen by about 5% annually. Had I owned the stock alone, I'd have an annualized return of 17.3%, but the covered call strategy has turned in an annualized return of 29.8%. At no time have I written calls at strikes that don't reflect what I believe to be a reasonable fair value, and thus would be fine parting with the shares -- though I'll admit that the most recent strike is at the very high end of my fair value range.

Beyond B-Wild
I'm not finished with B-Wild yet, and there are other "limited upside/limited downside" names to work this magic on. Consider computer peripheral-maker Logitech (Nasdaq: LOGI) -- facing stagnation in its core markets and relying on Google TV and high-definition video conferencing to reup its growth. Or perhaps look to credit ratings agency Moody's (NYSE: MCO). Now that it seems the market has accepted they're not going to be legislated into irrelevance but will rake in fewer fees from rating structured finance goo-gaws, the stock price reflects a more modest, low-growth future.

Even giant resurgent automaker General Motors (NYSE: GM), if you believe that the army of investors following it has reasonably efficiently priced the stock (and that its emergence from bankruptcy is a one-time only event), the current call pricing suggests annualized returns above 20%.

The Foolish bottom line
Market-crushing returns can be achieved with a well-chosen covered-call strategy. Stick to fairly valued stocks you're buying specifically to turn and write calls against, maintain one eye on valuation and one eye on where you're setting your strike, and you'll be surprised at the annualized numbers you can put up on this simplest of option strategies.

If you'd like to learn more about how you can use options to boost your returns, enter your email address in the box below to receive the Motley Fool Options "Options Edge" 2011 guidebook.