While resting his head on an Apple keyboard, Sir Isaac Newton, an avid stock trader, had an epiphany that would change the face of investing forever. Newton grabbed his quill and penned the words that would come to be known as the first law of stock market physics:
A stock price has three places to go - up, down, and sideways.
Later, Newton contributed a related and equally momentous third law (his second law didn't catch on):
Every stock price action triggers a profit-making reaction.
When a stock rises, long investors gain. When a stock declines, shorts benefit (and celebrate, I'm told, by clicking their cloven hoofs.) But who wins when a stock gets stuck?
For investors like me, who trade just-out-of-the-money (JOTM) covered calls, a tightly range-bound stock can offer great opportunity. A stock that offers high-yielding JOTM calls during an extended period of share price stagnation provides a so-called "income machine" (or what I call an "extended covered call"): The investor sells calls month-over-month until the shares are either called away or the stock price retreats significantly. This is the covered call trader's equivalent of "riding the wave," and it's narly.
For a sideways stock to work well as an extended covered call, a particular dynamic must be in place.
The company should be a mature, blue-chip company that is highly profitable, flush with cash, and a market leader with sterling fundamentals. At the same time, though, the company's long-term prospects must be subject to doubt, due to potential product obsolescence that threatens the company's domination. The tension between these bullish and bearish forces can create a "perfect storm" for a profitable extended covered call. The company's present strength, and expectations for continued success, boost the call option yields, while the questions surrounding the company's future provide resistance for the share price.
A great stock for this type of investment is Microsoft (MSFT).
I purchased 300 shares of MSFT in April 2011, and staked out an extended covered call that lasted through November 2011. I bought the shares for $24.99, and sold $25 calls 6 times before the shares were called away. To avoid assignment, I rolled my position three of the six times (in other words, my options expired three times, and I rolled options three times.) I earned an annualized yield of 19% on this investment, after expenses, and not including two dividend payments.
That's not a bad return for an eight month investment considering that I bought the shares for $24.99 and sold them for $25.
MSFT broke out recently, rising from $26 in January to its current price of about $31. As soon as you believe the shares have found resistance, run your yield numbers and -- just as a photographer urges a squirming child at a photo shoot -- hope fervently that MSFT please holds still.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
