For the purposes of this article, let's assume we have a
stock portfolio of conservative stocks, e.g., IBM, GE, etc.
We may be realizing moderate price appreciation of the
order of 5% annually plus dividend yields of 3%, for total
portfolio growth of 8 to 10% annually. One easy way to
boost our annual gains without increasing our downside risk
is to sell call options against our stock holdings. This is
known as a Covered Call.

A Covered Call is created by selling the appropriate number
of call options against stock in our portfolio. Let's
assume we own 500 shares of shares of IBM and IBM closed at
$104.69 on May 28, 2009. We are concerned the stock may
trade sideways or only slightly upward for the next few
weeks. We could sell 5 contracts of the June $105 call
options for $2.35, or $235 per contract. This brings $1,175
into our account. If IBM closes at any price less than $105
on June 19, the calls we sold expire worthless and we keep
the $1,175 we received and this represents a 2.2% return on
our investment in IBM. However, if IBM rallies to any price
above $105 by June 19, our stock will be "called away",
i.e., whoever holds those calls that we sold, will exercise
them to buy our 500 shares of stock for $105/share. In this
case, our account balance will stand at $105,000 plus the
$1,175 we received for the calls or $106,175. This
represents a gain of 2.5% for about three weeks.

There are always trade-offs for any investment strategy and
the covered call is no exception. The downside of the
covered call strategy, illustrated by this example, is that
we gave up any stock price appreciation beyond $105. In
return for surrendering that upside potential, we were paid
$1,175, or 2.2%. If we are using the covered call strategy
with conservative stocks like IBM, it is unlikely that we
will see big moves in the stock price very often. Most
months will see our call options expire worthless and we
will take in additional cash as the stock price moves
sideways or slightly upward. Adding one to two per cent
income per month to our conservative stock portfolio adds
up over the year.

Some traders use the covered call to increase the income
from a conservative stock portfolio when the market seems a
little slow. Others select and buy stocks with the express
purpose of selling calls against those positions. In either
case, the position should have a stop loss contingency
order placed with the broker to protect the downside. The
covered call strategy can be expected to yield about 2-3%
per month. Of course, every trade will not be a winner, so
it would be foolish to project annualized returns of
24-36%, but one can use this strategy to boost the income
from a conservative stock portfolio.

One forewarning is in order when using covered calls with
blue chip, dividend-paying stocks. If the call options you
sold are in-the-money, or ITM, as you approach expiration,
the calls are rarely exercised early if there is more than
$0.05 to $0.10 of time value left in the option premium.
However, if the stock is about to go ex-dividend, the call
may be exercised early to take advantage of receiving the
dividend. The dividend paid to the stockholder may outweigh
the time value lost upon exercise.

The Covered Call is a conservative strategy for boosting
the income of a blue chip stock portfolio. However, the
disadvantage of this strategy is the sacrifice of the gains
above the price of the call option sold. Selling calls
against highly volatile stocks would be a much different
strategy than our example with IBM. A Google (GOOG) covered
call would be much more aggressive; when GOOG is quiet and
trading within a range, we would make a nice return, but
when GOOG makes one of its $100 runs within a few weeks, as
it did recently, we would be caught with a $10 or $20
return instead of the $100 return. When covered calls are
used in conservative stock portfolios, boosted returns of
an additional 5% to 10% per year are reasonable
expectations, and this can be done without increasing the
downside risk.

----------------------------------------------------
Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years
of experience investing in the stock market and over seven
years experience trading equity and index options. He has
taken many classes on investing and trading through the
years and has discovered first hand how difficult it can be
to separate the financial facts from the marketing hype,
myths, and get rich quick schemes. He can be reached at:
http://www.ParkwoodCapitalLLC.com

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