Making money in the stock market typically involves "buying low and selling high."
That means buying stocks you think are undervalued, with the expectation that they'll rise. Of course, the higher you set your desired sell price, the greater your potential profits ... but the higher your risk that you won't earn those profits.
But there's one strategy that can enable you to "buy low and sell higher" without taking on extra risk.
Here's how it works
Suppose you own 100 shares of Wells Fargo
You can use an options strategy known as writing covered calls to increase your effective sell price. When you write a call, an investor pays you money up front for the right to purchase your shares by a certain date at a certain price. In this case, you could receive $0.85 per share for the promise to sell Wells Fargo, should it reach $31 by April 11, 2011.
Let's say Wells Fargo rises above $31 by April 11. Your shares would be "called away" from you at your target sell price of $31. But because of your $0.85 calls, your effective sell price was $31.85, an additional 3% return on your $26 investment -- earned in just five months.
Should April 11 roll around without Wells Fargo cracking $31, you get to keep your shares, keep the 3% you earned on your calls, and, if you'd like, write new calls.
Writing covered calls allows you to earn higher returns without having to take on extra risk. Of course, it's still possible your stock could fall in value, but if you write covered calls on stocks you're comfortable owning anyway, that's a risk you were already taking, and the call premium will help to cushion your downside.
The big drawback to writing covered calls is opportunity cost. Should Wells Fargo soar to $40, instead of capturing the upside had you simply owned the stock, you'd be locked into your effective sell price of $31.85. But if you were planning on selling at $31 anyways, that might not be a big deal to you.
For these reasons, despite the huge premium that a highflier like Baidu would earn you -- in this case, easily 7% in just a few months -- you probably wouldn't write a covered call on such high-risk high-reward stocks, because you'd be capping your upside while remaining exposed on the downside.
Five stocks for higher returns
What's the ideal stock for writing covered calls to raise your effective sell price? It will belong to a reasonably stable company (to protect your downside), but you won't expect it to soar overnight (so you won't miss out on a huge upside, should you be forced to sell).
Frequently, this means we're talking about stocks that may be somewhat -- though not drastically -- undervalued. Finally, since options premiums are generally higher for more volatile stocks, the strategy can be more lucrative with stable companies that still have moderately high betas.
With those criteria in mind, here are five candidates for writing covered calls on in order to earn higher returns:
National Oilwell Varco
Data from Motley Fool CAPS.
Make sure you're ready to sell
Writing covered calls to boost your effective sale price is a reliable strategy, especially when used on strong stocks selling at reasonable prices. And in down and sideways markets, covered call income can smooth out and pad your returns. Just make sure you're ready to sell a stock if it gets called away on you.
We're teaching -- and using -- covered call strategies in Motley Fool Options. We're also employing other option strategies to generate income and achieve better buy and sell prices on our stocks. If you'd like to learn more and receive a new free report on using options, simply enter your email below.
This article was originally published on June 22, 2010. It has been updated.
Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. Baidu is a Motley Fool Rule Breakers choice. National Oilwell Varco is a Motley Fool Stock Advisor recommendation. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.