A Simple Strategy to Boost Your Returns

Options trading writing covered callsOptions.

It's a word that makes you shiver with fear or salivate at opportunity. Options contracts have a reputation that hits both ends of the spectrum -- either a crazy, risky investing tool or one best left to the whiz kids at Goldman Sachs (GS) who have Ph.D.s in math and supercomputers at their disposal.

Commercials for options trading "schools" are in constant rotation on the business news channels. They make options sound like a sure-fire thing -- just like day-trading was supposed to be a sure-fire thing.

Of course, the only thing that's "sure-fire" about both these strategies is that most of the folks who try them will lose their shirts.

Even so, there are some things you can do with options that are far from crazy. In fact, there's one options strategy that's almost certain to add some extra money to your portfolio over time, without adding lots of risk.

A Simple Options Strategy for Everyone

Some options strategies are indeed very complex, but not this one. The technique known as writing covered calls is one of the simplest, lowest-risk options strategies going. It's perfect for times like these, when you want to be in less-risky investments like blue-chip dividend stocks, because it works with those stocks to boost your profits over time.

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When you "write" a "covered call," you create ("write") and then sell someone the right to buy (or "call") a specific stock at a specific price on or before a specific date. By "covered", we mean that the stock in question is one that you actually own. (If you write a call without owning the underlying stock, that's called a "naked call," and much like running around naked in public, it's a very risky strategy that's likely to result in losses and embarrassment.)

Here, in a nutshell, is how it works: Every few months, you make a little extra money by selling someone the right to buy your stock at a price that it probably won't reach before the option expires. Done three or four times over the course of a year, this can increase your returns by several percent -- without any additional risk of loss.

Yes, this is legal, moral, and ethical -- and actually very simple. Let's take a look at how it works.

Pick a Company for a Covered Call

Let's start by choosing a stock. But not just any stock: We want something big, sturdy, and slow-moving -- but with a dividend, to help our returns. Think big-name dividend stocks, like any of these:

Dividend yield
Bristol-Myers Squibb (BMY)
Chevron (CVX)
McDonald's (MCD)
Altria (MO)
Merck (MRK)
Pfizer (PFE)
Verizon (VZ)
Source: Daily Finance. Yields as of October 14.

If you don't already own a stock like one of these, you'd start by choosing one and buying some shares. Let's say that you bought 200 shares of Chevron at $100. You think that while it's unlikely to take a nosedive, it's also unlikely to go up in a big way over the next few months. (If you do think it's likely to go up big in the near future, it's not a candidate for this strategy. Choose another stock to write calls on.)

Your online brokerage can show you current options prices. Looking at mine right now, I see that $110 January calls on Chevron are selling for $1.37 as I write this. That means that you could write two calls -- each option covers 100 shares -- that give someone the right to buy those Chevron shares from you for $110 a share between now and mid-January, and you could sell them for $1.37 a share, or $274 in total.

3 Outcomes

So what could happen if you write those calls? There are three (and only three) possibilities:

  • The stock takes off. The stock goes way over $110 and someone exercises the calls. It might be selling at $150 in January, but your profits would be limited to the $15 per share from the sale, plus the $1.37 per share that you got for the calls, plus any dividends you might collect between now and then. You might be sad about giving up the big profits, but you'd still make over $11 a share, or about 11% -- a great return on a blue-chip stock that you only held for a few months.
  • The stock goes way down. That's a risk with any stock. But you were taking that risk anyway when you bought the stock, and at least you made $1.37 a share. And you can always write two more calls after those expire in January.
  • The stock stays stable. If you've chosen the right stock, this should be the most likely outcome. The upshot is that you held a stable stock during a period of market volatility, you collected a dividend, and you made an extra $1.37 a share by writing calls that won't be exercised. And you can repeat the process once those expire in January.

Long story short, the only risk -- aside from the inherent risk of owning whatever stock you choose -- is that you'll miss some of the upside if the stock takes off. But as I said above, if you think the stock is about to take off, it's not a candidate for this strategy.

The upside should be clear: Taking a few minutes to do this three or four times a year can add 3% or more to your profits. Add in the dividend on a stock like Chevron, and you could be making over 6% -- not too shabby on a "boring" stock in a tough market.

At the time of publication, Motley Fool contributor John Rosevear had no position in any of the stocks mentioned. The Motley Fool owns shares of Altria Group. Motley Fool newsletter services have recommended buying shares of Chevron, McDonald's, and Pfizer.

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