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Money From Nothing

Jan 6 2014, 7:36am CST | by

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Money From Nothing

IMAGINE SOMEONE handing you money for something you own in exchange for the right to buy it at a certain price for a limited period of time. It would be unusual to strike this kind of deal for your car or watch, but in the case of stocks it happens all the time. You can sell call options on stocks you already own and simply pocket the option premium if the option is never called. Indeed, your goal is for the options to expire worthless and never be called.

A growing number of investors are finding conservative options selling (or “writing”) a great way to wring extra income out of portfolios. “We’re boosting our returns by more than three percentage points per year. … Who wouldn’t want to do that?” asks Alan Salzbank, 58, of Gargoyle Asset Management . The RiverPark/Gargoyle Hedged Value Fund is up 25.7% in 12 months.

To sell a “covered” call on a stock (covered, because you already own the shares you’re promising to deliver) you must have at least 100 shares. Say you have 500 shares of Intel trading at $25 and a February 2014 call to buy at $25 (the strike price) is going for $0.80. Selling calls gets you $400 (500 shares x $0.80) minus transaction costs of about $10. If Intel is trading below $25 on the third Friday in February, the calls expire worthless; you keep the $400 plus your shares. Intel has a 3.7% dividend yield, with the 500 shares producing income of about $450 a year. The $400 from selling calls boosts your yield to 6.8%. Of course if Intel rises above $25 before expiration, you have to sell at $25–but you keep the $400 and any dividends already paid. A similar “expire worthless” strategy can be employed selling puts, but you need to have enough cash to make good on your promise to buy stock at a certain price.

Too complicated? A low-hassle alternative is to invest in “buy-write” closed-end funds, which employ covered-call strategies on individual stocks or indexes or sectors. Expenses run about 1% a year, and payouts are typically 7% to 10% a year. Monthly cash distributions come in the form of ordinary income, capital gains and return of capital, so these funds are best kept in an IRA.

In the sort of bull market we’ve had since 2009, broad market buy-write funds will underperform, since selling call options caps upside potential. But most of the funds sell for 9% to 13% below their net asset value, making them a good buy, says Alex Reiss, closed-end fund analyst at Stifel Nicolaus. One fund he likes is Nuveen Equity Premium Opportunity, which trades at a 9.7% discount to NAV. It is tilted toward technology, with 75% of stocks from the S&P 500 and 25% from the Nasdaq 100. It sells calls on those indexes that are about 2% out of the money, giving stocks room to appreciate.

Michael Jabara, an analyst at Morgan Stanley, likes AllianzGI NFJ Dividend Interest & Premium Strategy. Its portfolio is 75% value stocks and 25% convertible bonds, which “contribute additional yield and offer upside in a rising market while providing downside support in a falling market,” he says, noting that the fund sells at a 3.6% discount to its NAV. Discounts tend to get narrower when market sentiment improves, and widen as investors become more bearish.

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