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 Dow Chemical
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 $1.50 per share for the promise to sell Dow, should it reach $37 by June 17, 2011.
Let's say Dow rises above $37 by June 17. Your shares would be "called away" from you at your target sell price of $37. But because of your $1.50 calls, your effective sell price was $38.50, an additional 4% income on your $34 investment -- earned in just six months.
Should June 17 roll around without Dow cracking $37, you get to keep your shares, keep the 4% 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 Dow soar to $45, instead of capturing the upside had you simply owned the stock, you'd be locked into your effective sell price of $38.50. But if you were planning on selling at $37 anyway, 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 generally 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:
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.
Writing covered calls is just one of the techniques we're using to boost returns while managing risk at Motley Fool Pro. If you'd like to learn more and receive a new free report on three wealth-building strategies, simply enter your email in the box below.
This article was originally published 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 selection. Coach and FedEx are Motley Fool Stock Advisor recommendations. ABB is a Motley Fool Global Gains pick. The Fool owns shares of Coach and FedEx. 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.