Karim Rahemtulla says covered call investing is a strategy that offers something great in today’s market: steady, consistent income. Here, Karim explains how to make solid gains by selling call options on the shares of your favourite companies.

This from The Smart Profits Report:

Believe me, there are times I’m sure the last thing you want to hear about is the stock market. Sometimes, that’s true for me, too! And I understand that with each day that your portfolio losses grow, that’s when panic and/or depression sets in. When I was a rookie investor, I felt that way, because I didn’t think there was anything I could do.

But take it from me: At times like this, you must avoid panicking at all costs.

The thing is, markets are not one-way streets. And although it’s tough to argue that fact when we’re in a midst of an extreme correction that can only be compared to a 100-year flood, events like this can happen and we simply have to deal with it.

So this is not the time for a pity party or complaining. Here’s why…

Picking Through The Rubble For Strength And Extreme Value

While the stock market looks like a tornado has whipped through it over the past few months, lurking in the rubble are companies trading at valuations we haven’t seen for decades.

What’s more, they’re good, solid companies. True survivors that will allow you to recoup your losses as the market bounces back. And while it’s important to note that this may take some time, 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 the best way forward?

An Investor’s Best Friend

Over the past few months, one investment strategy 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 strategy for those who can look beyond the hype and promise of home run, triple-digit return promises and instead towards something that many investors crave right now: Steady, consistent income.

And it’s a strategy that has taught me that there are ways to benefit from volatile and even falling markets – perfect for the current climate.

I’m referring to covered call investing.

In a nutshell, the strategy has two parts…

1. You buy shares of a company.
2. You sell call options against your shares.

What does this accomplish? First, it allows you to reduce your 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, consistently reducing your original cost and setting yourself up for big returns in the future. Here’s how it works…

The Breakdown Of A Covered Call Trade

Let’s say you like General Electric (NYSE: GE).

You buy shares of GE at the current price around $17.

Against this position you sell GE $20 call options that expire in January 2009.

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, you can sell another option and collect more money and continue to lower your cost. The caveat here is that if GE closes above $20, you still only get $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 contracts. 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 $16 (your cost).

But I like to put my own twist on this. It’s not exactly the conventional way of covered call investing – but it’s a big reason why my Strategic Income service has managed to notch up a 70% win rate over the past 11 years. Here’s what I do…

An Even Better Way To Trade Covered Calls

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

My rationale is this: We’re essentially saying to the market that we want to own GE shares… but we want to own them at a lower price. Our price. Here’s how it works.

~ We buy GE at $17

~ We then sell the January 2009 $15 calls against the position.

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

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

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

You see how this works? We’re not betting that the shares are going higher… we’re actually saying that if they go nowhere or even lower, we still stand to make money as long as the shares are above our cost of $14 ($17 purchase price minus $3 premium received).

Three Chances To Win In A Market Like This? I’ll Take It!

The bottom line here is that we have three chances to win…

1. If GE shares rise, we win.
2. If GE remains flat, we win.
3. If GE shares fall – but not under $14 – we win.

I don’t know about you, but I like those odds – especially in a market like this.

But what happens if GE slides under $14?

Well, since our cost was lower than the $17 we paid for the shares, there is an excellent chance that we’ll be able to sell more options and reduce our cost even further, while increasing our upside potential.

Source: The Best Investment Strategy For A Market Like This… The Truth About Covered Call Investing