How I Earned Tens of Thousands in Extra Income

There's a lot to like about using covered call strategies in your portfolio. Writing call options can, for instance, help you generate additional income and provide some downside protection on the stocks you already own.

The catch -- and there's always a catch -- with covered calls is that, in exchange for the extra income and downside protection, you're agreeing to sell your stock at a certain price by a certain time. If the stock price soars above the agreed-upon price (the "strike" price) by the expiration of the options contract, the few percentage points of extra yield you received will be of little consolation as you watch your old stock trade higher.

That said, there are ways to manage this risk and make your covered call strategy more effective.

What not to do
At Motley Fool Pro, we've made frequent use of covered calls in the $1 million real-money portfolio we manage and added tens of thousands of dollars in extra income. And while we've had great overall success with covered calls, we have also made some mistakes along the way.

Here are two important lessons that we've learned or have been reminded of when considering a covered call strategy:

• Rarely write covered calls on commodity-driven businesses (or a commodity); you still have all the downside risk of the commodity, but you're capping the upside.
  
  One of our early purchases at Pro was Lindsay (NYSE: LNN), a small-cap irrigation and infrastructure company that was down on its luck during the recession. Many farmers had put off investing in irrigation equipment with depressed and volatile agriculture prices, but we really liked how the company was being managed.
  
  Over the next few months, the stock bounced back and forth between $30 and $45, so the next time the stock got near $45, we decided to write covered calls, thinking the stock was more or less range-bound. That time, the strategy worked and we kept our shares and the income from the covered calls.
  
  The next time we tried it, however, we weren't so lucky. Corn and other agriculture prices soared as well as the market's expectations for earnings growth at Lindsay. The stock jumped as high as $72.80, but we had to settle for a net sell price of $49.50.
  
  You can run all the valuation models you'd like, but the stock prices of commodity-driven businesses like Lindsay are hard to pin down; therefore, use covered call strategies sparingly.
  
  
• Rarely write covered calls on high-margin, recurring-revenue, low-cost business models like software. These stocks have strong upside if you give them time and they keep succeeding. Early in 2010, for example, despite the fact that we really liked Autodesk's (Nasdaq: ADSK) business and its prospects, we were concerned that the stock looked a bit pricey.
  
  With this in mind, we wrote covered calls on our position with the hope of getting paid some extra income or obtaining a better sell price. Since February 2010, Autodesk has continued to do well as a business (as we expected) and the share price, despite looking pricey to begin with, has surged an additional 60%. We've managed to hold onto our shares by rolling our calls forward, but it's come at a price, and the lesson has been a tough one to learn.

Even though covered calls aren't ideal for these types of investments, fortunately there are plenty of scenarios in which they are more useful.

The write stuff
High-growth businesses may not be great covered call candidates, but more mature, dividend-paying blue-chip stocks usually are.

Specifically, a good blue-chip candidate will have the following attributes:

• An ample dividend yield -- today, that's above 2.5%.
• Low volatility.
• Not too cheap, not too expensive (the S&P 500 average forward P/E is 15.8).
• A good dividend track record.

Here are five candidates to get you started:

Data provided by Capital IQ, a division of Standard & Poor's.

The major difference between writing covered calls on these types of companies and those we advised against is that you're less likely to run into a situation where the stock surges 50%-100% in a short period of time. Plus, writing covered calls on dividend-paying blue chips might even increase the total income you receive from the investment in the short term while you wait for the share price to appreciate in the longer term.

Foolish bottom line
As with any investment strategy, there are positive and negative consequences and right and wrong times to employ it. Covered calls are no exception -- they're best used on dividend-paying blue chip stocks and not on those with high-growth opportunities.

To learn much more about options and our favorite strategies or to find out more about Motley Fool Pro, which will open for just a few days on Tuesday, Jan. 18, to a small group of new members for the first time since last June, just enter your email in the box below. I'll be happy to send you a new free report, "5 Pro Strategies for 2011," that you can put to use in your own portfolio.