The Perfect Income Strategy For A Sideways Market

There are several compelling reasons to sell stocks. Yet, there are just as many strong arguments in favor of buying. The market, after all, is always a tug of war between bulls and bears.

Sometimes, neither will gain the upper hand, leaving the broader market drifting. There will certainly be volatile day-to-day price swings, but the larger trend could be sideways — what technical analysts call a “range-bound” market.

That’s not necessarily the worst thing. Even if the wind goes out of the market’s sails, dividend income can still put cash in your pocket each month and propel your portfolio. But there’s one strategy in particular that’s well-suited to deliver outsized gains in this type of environment.

I’m talking about writing covered call options, which is a great way to generate extra income on stocks you own — on top of any regular dividends.

Some people believe that options are inherently risky and speculative, and indeed they can be. But this tactic reduces risk and is even suitable inside IRA retirement accounts. Let me explain…

Covered Calls 101

By selling a call option, you are granting somebody else the right (but not the obligation) to purchase a stock from you at a pre-determined price (the strike price) before a specified maturity date. In return, you receive an upfront cash payment called a premium.

I’ll use an example from the portfolio of my premium newsletter, High-Yield Investing.

As I write this, CME Group (NYSE: CME) currently trades at $190 per share. There is a call option with a strike price of $210 that expires in December, trading for a premium of about $3.40. Each contract involves 100 shares, so selling one of these calls would net me $340 in immediate income ($3.40 x 100).

I get to keep that money regardless of what happens to the stock. Now, if the shares fail to reach $210 before the expiration date, then I simply pocket an extra $340 — adding it to the dividends I will collect over the period.

What’s the catch? Well, in exchange for the income, I would have to forgo any upside above and beyond the strike price. Suppose the shares rally sharply to $220. Then the call option would be exercised, and I would have to sell my shares to the buyer at $210, giving up any further appreciation.

Still, there are worse things than watching a stock you own climb from $190 to $210. That’s a gain of $20 per share (or $2,000 total), which, added to the premium income, would give me a total gain of $2,340 (for a total return of about 12.3% in three months, not bad).

What if the shares drop in value between now and September? Well, I still get $340 to help cushion the decline (versus zero for just holding the stock without any option writing).

You can see how this technique would be especially useful in a flat or declining market. If you’re a long-term holder of a stock but see little reason why the stock should surge in the short-term, you can pick a call option with a good chance of expiring worthless and still earn a little income on the side. And if everything works out, you will still get to keep your shares, which means you can always sell another option and earn another premium. And so on…

Using call options, you get paid to wait while the stock (or the overall market) is stuck in the doldrums.

Closing Thoughts

Now, while we don’t dabble in options over at High-Yield Investing, a number of dividend-oriented funds employ this same strategy — but on a larger scale, multiplied by thousands or even millions of shares.

The premium income earned from this strategy can add up significantly. The proceeds supplement ordinary dividends, giving fund holders a larger income stream — even when the market itself is stuck in neutral. I’ve featured a few of these funds for my premium readers over the years. The Nuveen Dow 30 Dynamic Overwrite (NYSE: DIAX) and PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP) are two notable candidates worth consideration.

Keep in mind, options prices are a function of market volatility. Traders are willing to pay more (so sellers collect more) when there is turbulence. By its nature, covered call writing limits upside potential in exchange for additional income and downside protection. So it stands to reason that these funds (also called buy-write funds) will lag the S&P in runaway bull markets. But they shine in uncertain conditions like we are in right now and can boost income when stocks aren’t going anywhere.

Regardless, this tactic is never a substitute for good old-fashioned stock picking. And that’s where my colleague Robert Rapier comes in…

Robert has been using strategies like this for years to generate more income than most investors think is possible. In fact, Robert can show you how to squeeze up to 18 times more income out of dividend stocks with just a few minutes of “work” each week. Click here for details.