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Covered Call Investing: How to Boost Your Bear-Market Income Right Now

by Karim Rahemtulla, Investment Director, Smart Profits Report
Thursday, November 20, 2008: Issue #889

Editor’s Note: The market suffered yet another downturn on a roller coaster ride of volatility today. And while we still recommend taking the “long view” when it comes to stocks, here’s a way to make a substantial amount of money as you wait for the inevitable turnaround… even if it’s two or three years away. This two-step strategy comes from our colleagues at the Smart Profits Report. We think you’ll find it profitable.

We understand that each day your losses grow, panic and depression can set in. Believe me, when I was a rookie investor, I felt that way. And I didn’t think there was anything I could do.

But take it from me: At times like these, we must avoid panicking at all costs. Although, it’s tough to argue that fact when we’re in a midst of a correction that can only be compared to a 100-year flood. The stock market looks like a tornado has whipped through it over the past few months.

But lurking in the rubble are companies trading at valuations we haven’t seen for decades. What’s more, they’re good, solid companies – survivors that will allow you to recoup your losses when the market bounces back.

Yes, this is a tough market. No doubt about that. But far from throwing in the towel or worrying about it, there are market strategies, like covered call investing, that can help you make money and even protect investments from future shocks.

It’s important to note that it may take some time for the market to rebound. But if you don’t have a horse in the race, you have no chance of winning, or even placing. So where does that leave investors like you and me? What’s our best way forward?

Covered Call Investing: A Two-Step Strategy for Steady Income

Over the past few months, one investment strategy – covered call investing – has risen to the top of the pack.

In fact, people whom I never thought would embrace it are now raving about its benefits. But understand that this is a two-step strategy for those who can look beyond the hype and promise of home run, triple-digit returns and instead toward something that many investors crave right now: Steady, consistent income.

And covered call investing is a strategy that has taught me that there are ways to benefit from volatile and even falling markets – perfect for the current climate. In a nutshell, this strategy has two parts:

You buy shares of a company.

You sell call options against your shares.

What does this accomplish? First, it allows you to reduce your cost basis in the share price by collecting a special “dividend” (known as a premium) from the proceeds of the options that you sold.

In a flat or “range bound” market, you can do this over and over again. You’ll consistently reduce your original cost and set yourself up for big returns in the future. Here’s how it works…

Breaking Down Covered Call Investing

Here’s a break down of covered call investing. Let’s say you like General Electric (NYSE: GE). You buy shares of GE at the current price around $17. Then, you sell GE $20 call options that expire in January 2009 against this position.

What this means, is that:

You’re obligated to sell your GE in January at $20 if – and only if – the share price is over $20 at the time.

If not, you keep your GE shares and any proceeds you received for selling the option.

If GE closes below $20 at expiration in January, the contract expires worthless. You can then sell another option, collecting more money and lowering your cost.

The caveat here is that if GE closes above $20, you still have to sell at $20. The loss of the upside is the price you pay for the safety of lowering your downside.

The money you receive for selling the option(s) is called the premium. For example, if GE January $20 options are trading for $1, you will receive $1 for each share that you own and have sold an option against it.

Remember, options trade in contracts, with each contract equal to 100 shares. So if you own 100 shares of GE, you can sell one call-option contract. At $1 per contract, you will receive $100 – 1 contract x 100 shares per contract x $1.

So let’s say you sell just one call option against your 100 shares. With the $1 premium, your cost in GE is now $16 and your upside is $4 – the difference between the strike price and your cost.

The extra dollar you picked up is like an extra 6% dividend ($1 divided by your cost of $16). And GE is already kicking out a healthy 9.25% dividend.

With the markets moving sideways and downward, there is an excellent chance that we’ll be able to sell more options and reduce our cost even further, all the while, increasing our upside potential. And who wouldn’t want that?

As I said, covered call investing is an excellent strategy to use in a market like this.

Good investing,

Karim Rahemtulla

Editor’s Note: To get Karim’s specific covered call recommendations delivered via e-mail, learn more about his trading service – Strategic Income.

Today’s Investment U Crib Sheet

Karim recommends another way to use covered call investing …

Instead of selling a call option above the price at which you buy the underlying shares, you sell it below that price.

The rationale is this: You’re essentially saying to the market that you want to own (for example: GE) shares… but you want to own them at a lower price. Here’s how it works:

Buy GE at $17

You then sell the January 2009 $15 calls against the position.

For doing so, you’ll automatically get $2 back – known as the “intrinsic value” ($17 minus $15). But you’ll get more.

For time and risk, you’ll pick up an extra $1 to make the total premium $3 ($2 intrinsic plus $1 for time and risk). That lowers your original cost in GE to $14.

So you stand to make $1 profit on the trade, as long as GE closes above $15 in January. If this happens, your return is about 7% in a couple of months – a full $2 below the current price.

You’re not betting that the shares are going higher… if they go nowhere or even lower, you still stand to make money as long as the shares are above your cost of $14 ($17 purchase price minus $3 premium received).

The bottom line here is that you have three chances to profit from this transaction…

If GE shares rise, you win.

If GE remains flat, you win.

If GE shares fall – but not under $14 – you win.

Covered calls aren’t the only way to make money from options. Just over a week ago, Lee Lowell showed you how “put” options can be used to buy stocks for less, learn more in Investment U Issue #882, Put Option Selling: Get Paid to Buy the Stocks You Want.