Stock Tip: Extend Gains with Covered Calls

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The stock market’s wild ups and downs are nerve wracking, but can provide an opportunity for savvy investors willing to dabble in the options market.

Generally, options are best left to the professionals, as most amateurs don’t have the knowledge, time or discipline to trade in this fast-moving and dangerous market. But conservative investors can profit from “covered calls,” a way to earn a little extra on stocks or exchange-traded funds you already own, according to Morningstar Inc. (Stock Quote: MORN).

This maneuver can be especially profitable in times of high volatility, which raises the premiums, or prices paid on options contracts.

An option gives its owner the right to buy or sell 100 shares of stock at a set price for a period of days, weeks or months. A “put” is the right to sell, a “call” the right to buy.

A trader who thinks the Standard & Poor’s 500 will rise might purchase a call giving the right to buy shares of an S&P 500 ETF at today’s price anytime during the next few months. If the index rises, the option can be “exercised” to buy shares at the designated price, producing a profit. If the index falls, the calls will expire worthless, but the trader won’t suffer any additional loss because he does not own the shares.

Traders like options because a small amount of money can be used to control a large number of shares, offering very large profits on winning bets. On the other hand, if the option expires worthless, everything spent on the premium is lost.

Currently, the SPDR S&P 500 ETF (Stock Quote: SPY) trades at around $108 per share. It would cost $10,800 to buy 100 shares to bet on a price increase. But options giving the right to buy shares at $108 through Sept. 10 cost just $6.50 a share, allowing traders to control 100 shares for $650. For the trader to make money, the ETF would have to rise above $114.50, to cover the cost of both the shares and the premium.

On the other side of the deal is the “writer” of the call, an investor who owns the ETF shares and is willing to sell them for $108 if the option is exercised. The writer receives the $650 premium, and keeps it regardless of whether the option is exercised.

“Covered call writing is a low-risk way to earn a profit from an existing holding in your portfolio, particularly when volatility is high or you have the view that the underlying security is fairly valued or has limited upside potential,” Morningstar says.

Of course, the strategy makes sense only if you are willing to part with your holding at the specified “strike” price.

One variation is to write a covered call with a strike price somewhat higher than the current level, reducing the chances the option will be exercised. September SPY calls at a $115 strike price currently carry premiums around $3 a share. You could pocket $300 on a 100-share block and not have to sell them unless the price exceeded $115.

Conservative investors repeat this technique over and over to squeeze a little extra return out of their stocks and ETFs.

To trade options, you must set up an account with a broker and sign a statement that you understand the risks. Your broker will have more information. The Options Industry Council has a primer on its Web site.

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