Get Naked For Income Matthew Schifrin, 11.19.10

Safety and income. It's what investors crave these days. Everyone is nervous about the stock market and Bernanke's bond bubble. Safe sources of income like bank CDs and Treasury bonds pay next to nothing. Muni yields are a joke, plus many are fraught with risk.

But there is another relatively safe way to generate income that most investors rarely consider. Stock options.

Options need not be speculative. They can be a smart way to generate income and manage portfolio risk. Discount brokers offer a host of free online tools to educate you about options and keep you from trading your way into the poorhouse.

This new column is devoted to the investment advice and insights of outstanding self-directed investors whom I call the Warren Buffetts Next Door.

Options investor Robert Krebs, 58, is a great example. By day Krebs is an engineer who designs microchips at Western Digital in Orange County, Calif., but when he isn't working, he spends hours online tending to his portfolios of stocks and options. His returns have been impressive.

On the website, where he is known as "dig4value," the stocks he has picked in its quarterly contests since 2004 would have turned $10,000 into $46,600 versus $11,500 for an investment in the S&P 500. But those returns don't speak to the opportunistic options strategy Krebs has adopted. His goal: Add 1.5% per month in income to his portfolio returns by selling calls and puts.

Like most novices dabbling in options Krebs started out buying calls, which give the contract holder the right to buy 100 shares of stock at a specific strike price for a specified period of time. But in the 1990s Krebs read an article reporting that 75% of all options expire unexercised and worthless. It's even worse for put options, at 83%. Krebs had an investing epiphany: "If options are a zero-sum game, then sellers are the ones making the money," he thought.

So today Krebs uses options selling (writing) strategies to generate income. He sells out-of-the-money covered calls and naked puts. One of the stocks Krebs has owned is offshore driller Transocean. Let's assume Krebs owns 1,000 shares of Transocean at $70 per share. If Krebs sells ten $3 call contracts at a strike price of $75, expiring three months out (say, February 2011), he would receive $3,000 in his account.

If the stock fails to rise above $75, Krebs gets to keep the income, which represents $3,000 over the course of three months. Krebs would continue this strategy every quarter, hoping to earn an extra $12,000 per year on his portfolio holding of Transocean. This would produce a yield of 17%.

If the stock rises above $75 and Krebs wants to keep it in his portfolio, he merely buys those call options back. He may take a loss on the calls, but he avoids selling Transocean and paying capital gains on his 1,000 shares.

The other strategy that Krebs favors is what he calls naked short puts. It sounds dangerous, but it's actually the equivalent of a covered call from a risk-reward standpoint.

Working in the semiconductor industry Krebs likes Intel but thinks the stock is a bit rich at $21.

So Krebs has opted to sell January 2011 puts with a strike price of $20, with the puts trading at 50 cents per share. For ten contracts (representing 1,000 shares) that would amount to $500, deposited into his account.

If Intel falls below $20 and Krebs' put option is exercised, his account would purchase 1,000 shares for $20,000. However, his effective price is $19.50, or $19,500. By contrast, if Intel appreciates in price, his puts expire worthless and Krebs pockets the $500.

Krebs uses naked puts as a way to build a low-cost position in a stock and gets paid to wait. Note that brokers usually require at least 25% of the equity cost in cash in your taxable margin account to engage in naked put selling. In IRAs it's 100% cash equity.

At any given time Krebs has up to 200 options positions open. Currently he owns shares in mortgage REIT Annaly capital and Cypress Sharpridge, which yield 15% and 18%, respectively. Krebs sells covered calls on these for income.

One stock Krebs has been selling naked puts on is biotech Exact Science. The company uses a "stool-based" DNA technology for early detection of colorectal cancer. Krebs would like to own the stock, which is up 127% in the last 12 months, but he thinks it's too pricey. So he has been selling puts underneath it at lowball strike prices of $2.50 and $4. He doesn't own shares yet, but the income its options produce has been keeping him happy.

Matt Schifrin is Investing editor of Forbes and author of The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard Of and What You Can Learn From Them.

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