One way to profit from market volatility

@FortuneMagazine October 10, 2011: 6:01 AM ET
Selling call options on your stocks holds little risk

FORTUNE -- Chaotic markets have left investors scrambling for ways to boost returns without taking on excessive risk. But there's a simple strategy that can make a virtue out of market volatility: Build a portfolio around high-quality stocks with generous dividend yields to offer a cushion against market swings, and juice even more income from those stocks through the strategic use of options.

Options contracts give an investor the right to buy or sell a stock at a future date and specific price. The demand for options, along with their prices, typically rises when market volatility flares up, as has been the case of late. The Chicago Board Options Exchange Volatility index (VIX), the most common measure of investor fear, spiked above 40 during August and September -- double its long-term average. As a result, buyers have been flocking to options.

And therein lies your opportunity. To reap more income from dividend-paying stocks you already own, you can sell "covered calls," granting another investor the right to buy a stock you own at a higher price in the future (known as the strike price). You pocket money from the option sale, which you get to keep no matter what happens with the stock down the road. "It's a strategy that can improve your odds of success and provide superior returns over time," says Michael Khouw, director of equity derivatives trading at Cantor Fitzgerald.

Here's how. Let's say that you bought the stock of drug maker Abbott Laboratories (ABT, Fortune 500), which was trading at $51 a share in mid-September and had a dividend yield of 3.8%. You could then have sold a call option, which at the time was trading for $1.03 a share, granting another investor the right to buy your Abbott shares for $55 at any point until mid-January. If the stock price stayed below $55, you would continue to own the stock, but you'd still keep the $1.03 per share you got for selling the call option. When it expired, you could sell another round of options against the stock, boosting your income yet again.

If, on the other hand, Abbott shares traded above the call option's $55 strike price before mid-January, you might be forced to sell your shares and miss out on some of the upside in price appreciation. In that case, you'd realize a 7.8% profit on the stock, pocket the $1.03 per share from the option sale, and collect the quarterly dividend payment. Not exactly a horrific outcome.

To reduce the likelihood of being forced to sell a stock you want to hold onto, Khouw recommends selling call options with a strike price comfortably above the current market price -- say, 10% higher -- even if that means settling for a smaller cash payment upfront. "This is not a trading strategy -- it's an investing strategy," he notes.

And it's a strategy that makes sense for the foreseeable future. "Heightened volatility isn't going away anytime soon," says Sam Stovall, chief investment strategist for Standard & Poor's Equity Research. You may not enjoy the rocky ride, but at least you can capitalize on it.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This article is from the October 17, 2011 issue of Fortune. To top of page