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 worksSuppose you own 100 shares of Intel (Nasdaq: INTC). It's a stable company that draws an enormous competitive advantage from its scale, so you don't expect it to collapse overnight. While you wouldn't sell at current prices, with a P/E just below 20 and moderate growth estimates, you don't exactly expect shares to be a quick double or triple. If Intel rose from its current price of $21 per share to $24, however, you'd consider the stock fairly valued, and you'd be willing to sell.
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 $0.80 per share for the promise to sell Intel, should it reach $24 by Jan. 21, 2011.
Let's say Intel rises above $24 by Jan. 21. Your shares would be "called away" from you at your target sell price of $24. But because of your $0.80 calls, your effective sell price was $24.80, an additional 4% return on your $21 investment -- earned in just seven months.
Should Jan. 21 roll around without Intel cracking $24, you get to keep your shares, keep the 4% you earned on your calls, and, if you'd like, write new calls.
The downsideWriting 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 Intel soar to $35, instead of capturing the upside had you simply owned the stock, you'd be locked into your effective sell price of $24.80. But if you were planning on selling at $24 anyways, that might not be a big deal to you.
For these reasons, despite the huge premium that a highflier like Baidu (Nasdaq: BIDU)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. (There is, however, another options strategy that you can use to profit, whichever way a volatile stock such as Baidu moves.)
Five stocks for higher returnsWhat'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:
Company | P/E | Beta |
|---|---|---|
15.3 | 1.31 | |
17.2 | 1.96 | |
19.6 | 1.54 | |
24.2 | 2.00 | |
18.5 | 1.25 |
Data as of June 21, 2010.
Make sure you're ready to sellWriting 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.
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