If you’re a conservative investor, trading options may sound way too speculative. But used correctly, they can work wonders. And they’re not as complicated as you may think.
I’m not suggesting that you use options to shoot for the moon. Instead, I recommend using a specific option trading strategy called “writing covered calls,” to generate immediate and steady income and reduce your risk.
Covered call strategies are ideal when you own a stock that you are confident will move up slowly or is temporarily stagnating. That’s why this often-ignored strategy is ideal for risk-averse investors. The stock trades sideways, you win. The stock goes down, you win. And if the stock goes up, you just win a little less than you would if you didn’t write the option.
When you put the bait out at the best time — which is whenever the stock trades near three-month highs — you maximize the odds that you’ll just keep cashing in those option premiums.
Options Trading Basics — Covered Calls 101
An option is a right to buy or sell a stock at a specified price (called a strike price) by a specified deadline (expiration or exercise date). One investor buys that right from another via an options contract. The seller of that contract is called the “writer,” and the buyer pays the writer a premium for it. (We’ll come back to this in a minute.)
The option to buy is a “call option,” and the option to sell is a “put option.” Someone buying a call option is betting the stock will rise. Their option allows them to buy at a lower value, and becomes more valuable as the stock rises. The opposite is true with a put option — the buyer is betting on a falling stock price, and the option becomes more valuable as the price falls.
Things are different from an option writer’s perspective. Regardless of whether the buyer exercises their option, the writer collects a premium for the option contract. That premium can give you a nice stream of income that you keep even if the buyer doesn’t exercise the option.
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That said, if for example you write a call option on a stock you don’t own, you are taking on considerable risk, because the stock price could rise infinitely, and you could be forced to buy it at any price, while the buyer only has to pay you the strike price for the stock. That’s why I advise what’s known as a “covered call” strategy.
A covered call is when you write a call option only on shares you own — enough shares to “cover” the contract, and you, if the buyer decides to exercise the option. Because you already own the shares, all you risk is having to give them up and miss out on potential gains in the stock. But in the meantime, you get to collect that nice options premium and use it however you want.
Creating “Dividends” Through Covered Calls
What many conservative investors don’t realize is that big hits in options are generally quite rare. Most options expire with little or no value, like an ice cube melting in your hand. As a result, there’s a wonderful opportunity for conservative investors to make money (and reduce risk) by selling options — or, as it’s called in the trade, “writing” them. The safest tactic is to write call options against stocks you already own.
Let’s say you’re holding 100 shares of Google Inc. (NASDAQ: GOOG). Although GOOG is considered a blue chip in technology, the company pays no dividend, making the shares inherently somewhat riskier than, say, IBM or Microsoft. As a Google shareholder, you might sell calls against the stock to bring in some income. With the stock around $510, you could earn $9.80 by writing a call option that expires in June with an exercise (“strike”) price of $530. Granted, if GOOG’s share price surges past $530 between now and June, your stock may be called away from you. But you’ll pocket $530 plus $9.80 — a total of $539.80 if the buyer of the call exercises the option. (I’m disregarding commissions here, because they’re small if you deal with a discount broker.)
What if GOOG slides instead, or simply meanders in the $530 to $550 range? If the share price remains below $530 between now and June, you’ll simply keep the $9.80. Do this four times a year, and you’ll in effect earn a 7.7% dividend on your Google stock. The options premiums you rake in won’t necessarily save you from loss, but they’ll dampen any loss — and they could increase your profits if the stock rises gradually (rather than steeply) in the months ahead.
In addition to Google, almost any of the low dividend or no-dividend stocks I’ve recommended could serve as appropriate candidates for covered call-writing (i.e., you already own the stocks you’re selling calls against). I especially encourage you to write calls on Apple Inc. (NASDAQ: AAPL), Cisco Sys Inc. (NASDAQ: CSCO), Halliburton Co. (NYSE: HAL), Hewlett-Packard Co. (NYSE: HPQ), Kohls Corp. (NYSE: KSS), Oracle Corp. (NASDAQ: ORCL), Research in Motion Ltd. (NASDAQ: RIMM) and Zimmer Holdings Inc. (NYSE: ZMH). For best results, set your bait out whenever the stocks trade near a three-month high.
Don’t Want to Monitor Options on a Slew of Individual Stocks?
What if you don’t want to bother monitoring options on a slew of individual stocks? You can still improve your portfolio’s risk-adjusted returns by purchasing a fund that writes options against the stocks it owns. One such vehicle is the exchange traded PowerShares S&P 500 BuyWrite Fund (NYSE: PBP). As the name implies, this fund invests in the 500-odd stocks that make up the Standard & Poor’s Composite Index. It then writes call options against its holdings to generate additional income.
The results, so far, have been heartening. In 2008, PBP lost money, as you would expect in a severe bear market, but it gave up 700 basis points less than the S&P 500 index — a good defensive showing. Last year, when the market rocketed higher, PBP (at net asset value) trailed the index by less than 200 basis points. Thus, for the two years taken together, PBP is cruising comfortably ahead of the market. At 75 cents a year per $100 invested, PBP’s expenses are higher than a typical index fund, yet lower than a standard actively managed mutual fund. All in all, PBP strikes me as a fair-and-square deal: A modest ongoing fee buys you a rich dollop of protection.
Because PBP is a partly hedged vehicle, you don’t need to be as strict about buy limits as you should be with individual stocks. Still, you’ll do best to buy whenever the share price has dipped at least 3% from its most recent 52-week high.
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