As income investors, we’re more interested in long-term returns than short-term trading profits.

That means we don’t use options much…

But there’s one options strategy that – in certain market conditions – can actually boost our income without adding a ton of risk to our portfolios.

If you’re not using this strategy, you’re missing out on a tremendous opportunity to increase your long-term wealth.

[ad#Google Adsense 336×280-IA]In short, I’m talking about selling call options on some of our core holdings.

Selling call options can really boost our returns, as the options often expire without being exercised, allowing us to pocket the premium and, if we like, repeat the process.

Let’s take a look at how this strategy can be employed profitably.

After all, options can be pretty confusing at times.

Where Options and Income Meet

First of all, how does selling calls boost our short-term profits?

Well, if we make four 2% premiums on three-month options over a year, we’ve effectively added 8% to our income on that holding – a truly juicy uplift. The downside risk is that our holdings may be called away from us, leaving us with the difficult decision of whether to buy them back at a higher price.

Suppose we hold McDonald’s (MCD), which is trading at $91.52 as of this writing. The bid price for a $95 call option with an expiry date of February 20 is $1.25. Thus, if we sell such an option and it’s not exercised, we realize a return of $1.25/$91.52 = 1.4%.

Of course, if McDonald’s is trading at $100 on February 20, we’d have sold it for a total of $96.25 (the $95 strike price plus the $1.25 option premium) and lost out on those additional gains.

Opting for Options

Obviously, there are markets in which selling calls is unwise. If we’d employed this strategy in early 2009, when the markets were low, we would’ve seen our holdings called away.

Today, though, the markets are close to record highs, which means the strategy makes more sense. Indeed, if the markets fall out of bed, we’ll lose on our holdings… but we would’ve done so anyway, and at least we’ll have the premiums on the options we sold to console us.

Meanwhile, the price we get for the options we sell depends on the “volatility” of the underlying stock – a more volatile stock has a higher-priced option, while a less volatile stock has a lower-priced option.

That means a very stable stock such as Emerson Electric (EMR) – which has increased its dividends every year since 1957 – may be a lovely investment, but it won’t get you great options premiums.

The stocks on which you sell call options should therefore have reasonable volatilities, say 20% or above for options “at the money.” Provided the volatility is sufficient, income stocks are ideal, because you get income from the call option premiums as well as the dividends.

The stocks should also have a substantial market capitalization, with decent trading volume on the options. A $500-million stock will typically have options that trade infrequently, so bid/offered spreads on the options will be wide.

Above all, the stocks you choose should be ones you want to hold in the first place. Buying an overpriced stock to sell call options is dangerous, as you risk a substantial capital loss if the price corrects.

Choosing the Right Stocks

One quite obscure stock on which this strategy works is B&G Foods (BGS). B&G has a nice business niche: It buys small, tired brands from the big food conglomerates and revitalizes them.

At the moment, its trailing P/E is 33x… but it’s been affected by non-cash charges. On an operating basis, its trailing P/E is lower. The stock also pays four $0.34 dividends annually, for a 4.6% yield. And its May $30 calls, which have a 27% volatility, are traded at a $1.50 bid, so you’d make 5.1% on the current share price if you sold them.

At the other end of the fame spectrum, Apple (AAPL) yields 1.7%, so it may not be quite suitable as an income stock, though many people own it anyway. Its July $115 calls trade at a $7.35 bid, with an implied volatility of 31%.

You could sell those and make an extra 6.7% on your money. If you get called away, you would effectively have sold Apple for a total of $122, above its all-time high of $119.75.

Finally, for an income stock with higher volatility, Freeport-McMoRan (FCX) is worth looking at. Here, the implied volatility on its March $19 options is 51% and its yield is 5.3%. By selling March $19 calls for $1.48, you can achieve a truly juicy combined yield of 46.3% – 41% annualized on the option, plus 5.3% on the stock.

The snag here, as I mentioned [recently], is that the company may record a big write-off in the fourth quarter, and the dividend isn’t quite secure. Thus, you probably want to wait until fourth-quarter results are announced if you don’t own it already.

Bottom line: Even for conservative, income-oriented investors, options can be a useful tool in the right market environment.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily