Those of us on a quest for extra income may find it in an unexpected place -- our portfolios of stocks. Since it's not likely that many stocks will rack up double-digit returns in the year ahead, taking advantage of a simple options strategy to wring more return out of our portfolios makes a lot of sense.
The way to get this extra return is by selling covered call options on your stocks or exchange-traded funds. When you sell, or "write" in options lingo, one of these contracts you give someone the right, but not the obligation, to buy shares from you at a set price for a specific period of time. As long as you're comfortable with all possible outcomes, including having to sell your stock to an option holder, you can get extra return from a trade you were willing to make anyway. If an option doesn't get exercised, you keep your stock and the amount you were paid for writing the option -- called the premium. Sure, premiums may seem small -- for example, $1 per share for selling a 60-day covered call at $55 on a $52 stock. But that $1 is about 2% of $52, and if the option expires worthless, you've made 2% over 60 days. When annualized, that's a 12% return.
The trade-off: If the stock jumps and the option holder chooses to exercise, you will miss gains above $55. If the stock gets to $65, you still get only $55. "Covered-call writers need a 'what if?' plan in place when they initiate a trade," says Jim Bittman, senior instructor at the Chicago Board Options Exchange's Options Institute.
Here's how the strategy works. Let's assume your outlook for a stock is neutral or mildly bullish. If you're willing to sell a stock when it reaches your target price, you can write an "out-of-the-money" option. Say you think Coca-Cola (KO), which trades at $40.53, could hit $42.50 sometime before May, and you would be happy to get that price. You can sell a call option with a $42.50 "strike price" and a May, 2005, expiration and collect a premium of $1.05 per share, or $105 for a 100-share contract. That's a 3.3% return if the option isn't exercised. If it is, the return is 8.3%. That includes a $1.97 profit per share on the stock if you bought it at $40.53. "In effect, you've put in a limit order [an order to sell a stock at a preset price] and been paid for doing it," says Todd Salamone, vice-president for research at Schaeffer's Investment Research.
If you think a stock will tread water, you might write an "at-the-money" option. The price at which you'd sell is the current market price. Buyers are betting that the stock will go up and that they'll be able to buy it from you at a below-market price. You can also sell "in-the-money" calls, giving someone the right to buy, say, your $22 stock at $20 if it dips to that level. That puts a floor on the stock, and you'll be paid more for writing such a call. But recent tax changes have limited the appeal of in-the-money calls, so move carefully.
When plotting your options strategy, remember to factor in commissions, which vary widely between brokers. If you're writing less than 30 contracts, Charles Schwab Corp. (SCH) charges a fee of $29.95 for the first contract and $2 for each additional one if you trade over the phone or online. A deep-discount broker such as optionsXpress charges $1.50 per contract with a $14.95 minimum per trade.
You may want to start out writing covered calls using a full-service broker, and then, when you get the hang of it, switch to a discount broker to save money on commissions. First though, check out the options education courses online. You can take free online tutorials, and fee-based interactive seminars, at the Chicago Board Options Exchange's Options Institute (www.cboe.com), and click on "Learning Center"). Another source to check for online tutorials and seminars in your area is the Options Industry Council (www.888options.com). The time and energy that you invest in educating yourself will help ensure that exploring your options is as profitable as possible.
Corrections and Clarifications
In "Squeeze your portfolio harder" (Smart Strategies, Dec. 27-Jan. 3), a Charles Schwab representative provided BusinessWeek with outdated pricing for options trades made by phone or online. Correct pricing for investors trading online and writing any number of contracts is a $9.95 commission and $1.40 fee for the first contract and $1.40 for each additional one; trading by automated phone is $29.95 for the first contract, plus the $1.40 fee. Also, the accompanying table ("Getting a premium") on covered call options should have noted that dividend payments received over the life of the option are included in the quoted returns.
By Suzanne Woolley