A New Way to Turn Up Covered-Call Opportunities

People usually think of covered-call writing as the turtle's route to wealth and glory. And in a market ruled by hares, it's little wonder you don't hear much about it. With covered calls, returns kind of trickle in like the yield on some dull muni bond. Who wants that when last year you could have made 84% just betting on the Nasdaq Composite?

Now there's a new Web site, Optionfind.com, that might make covered-call writing seem downright sexy. Seriously. It functions just like an online stock-screening tool, except it screens for covered-call opportunities that can produce returns on par with a hedge fund -- and probably with a lot less risk.

More on the Web site in a moment. First -- quick review -- what exactly is a covered call?

When you sell a covered call what you're really doing is giving the buyer the right -- but not the obligation -- to purchase shares of stock from you at an agreed-upon price, called the strike price. The buyer believes those shares will increase in value, and for that reason he or she will pay you a premium for the calls. Think of that premium as income. With blue-chip stocks, the premium often amounts to 4% or more of a stock's value. And you can pick up that 4% each time you sell a call. So, if you sell eight covered calls per year, your annual return on the stock amounts to 32% -- actually, higher when you factor in compounding.

HD, For Example

Here's how the whole business works: Before you sell a covered call, you first purchase the underlying stock. So, let's say you like Home Depot(HD - Cramer's Take - Stockpickr), recently selling at 61 11/16. A quick check of call option prices on the Chicago Board Options Exchange shows that February Home Depot calls with a strike price of 60 are selling for 4 5/8. That works out to $462.50 per round lot, since options must be bought and sold in round, or 100-share, lots.

The 400 shares of Home Depot will set you back $24,675. Then you sell 4 HD February call options and receive the tidy sum of $1,850. Of course, you can't count all of that as profit. Since the call's strike price was 1 11/16 points below what you paid for the 400 shares, you'll need to subtract $675 (400 shares x 1 11/16 points = $675).

That still leaves you with a profit of $1,115, which represents a return of just over 4.5% for the six weeks until the option expires. Annualized, your return works out to just over 36%, after you subtract transaction fees of about $60 for each play. (Amounts vary with each online brokerage.) To compute the annual return, I'm assuming you sell a new covered call on Home Depot (or another stock paying a similar premium) about every six weeks. And, as I mentioned, that annualized return doesn't take compounding into account.

Let's say that between now and late February, when the options expire, your Home Depot shares rise to 70. In that case, the call buyer would make out like a bandit, since you're obligated to sell him or her your shares for $60. Then again, your profit would still be $1,115. And remember, the money came at a pretty low risk. If Home Depot's shares drop in price, the calls expire worthless. And you still get to keep the $1,115.

As I said, this is the turtle's way to wealth. But if you're a fairly savvy investor and you want a low-risk way to build a nest egg, covered calls could be your meal ticket. Try to find a mutual fund that consistently returns 36% over a decade or more. In fact, covered-call writing is deemed conservative enough that it's the only options strategy allowed within an IRA and other tax-deferred retirement plans. If you want a more complete explanation of covered calls, read Michael C. Thomsett's book, Getting Started in Options.

Besides their limited upside potential, do covered calls have any other drawbacks? Indeed they do. You need to take a fairly large position in the underlying stock -- several hundred or even 1,000 shares -- otherwise broker fees will eat up your profits. That means you need a fairly large portfolio (say $60,000) in order to trade covered calls effectively, or you risk having your funds concentrated in just one or two stocks.

Screening For Opportunities

Here's another drawback: Until now, it has been tough to find out which call options paid decent premiums. The cumbersome way would be to first develop a list of stocks you like, then painstakingly check out their option chains on the CBOE Web site. You could buy a $2,400 software program called Optionstation that offers state-of-the-art pricing analysis. Alternately, subscription Web sites such as Wall Street City and OptionsAnalysis provide option strategies for $34.95 or $79.95 per month, respectively.

But Optionfind.com is free. The site was launched in October by Joshua Oskwarek, president of Productivity Systems, a Connecticut Web development firm.

So far, Oskwarek's site gets only about 1,000 hits a day. Never mind that. It's a full-fledged options screening program. Just like stock screens at sites such as Stockpoint.com that sift through thousands of stocks and find those that meet your criteria, Optionfind.com lets you compare the infinitely greater number of stock/option combinations -- and likewise develop a winning strategy.

For example, you can select low-priced stocks (say, between $10 per share to $25 per share) that come with relatively high earnings per share (say, $1 or more), plus high volume (say, more than 100 option contracts traded daily). Theoretically, this simplified search would call up stocks that are:

• Relatively cheap to buy in round lots.
  
• Good bets for future gains (as indicated by the high earnings per share), meaning call option buyers would likely pay a premium because they would expect more growth in the future.
  
• Liquid enough so that trying to sell your five or 10 calls won't tilt the market.

Interestingly enough, when I input the above variables into Optionfind.com's search engine the lone stock to come up is Xerox(XRX - Cramer's Take - Stockpickr), which offers potential annualized covered call writing returns of nearly 50%.

When I adjust the earnings-per-share variable to just under $1, one of the stocks spit out is oil-and-gas-equipment supplier McDermott International(MDR - Cramer's Take - Stockpickr). Recently recovering from months of decline, the stock has a price-to-earnings ratio of just 11.5. Last November, Dallas-based Frost Securities called McDermott "one of the best buys on Wall Street." Annualized covered-call returns are just over 28%.

So yes, if you're a covered-call writer there are potential winners out there. And it only takes a search engine like Optionfind.com to discover them -- provided you ask it the right questions. If you'd rather not fill in all 27 blanks on Optionfind.com's search engine questionnaire, you can, in essence, follow the money. Optionfind.com lets you specify an annualized rate of return, say 100%, and the program will spit out a list of covered call combinations that have the potential to yield that amount on an annualized basis.

Granted, it's the more volatile stocks that provide the higher returns. Graphics software maker Engineering Animation(EAII - Cramer's Take - Stockpickr), for example, definitely has its ups and downs. The stock fell from a high of 63 a year ago when management admitted to discrepancies in its numbers. Recently selling at 9 3/8, February call options with a strike price of 10 were selling at 1 1/16 -- which would yield a 139% annualized return after transaction fees, assuming you purchased 1,000 shares and the stock then rose to 10 or higher.

Very few turtles would want to risk $9,375 on 1,000 shares of a little-known tech company with a jack-rabbiting stock price. But why bother when writing covered calls on blue-chip stocks such as Xerox can bring home solid 50% returns? Slow and steady wins the race. And returns like that are worth coming out of your shell for.