Make the Calls

 | Oct 30, 2013 | 4:00 PM EDT
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As foolish as it is, the biggest reason many investors don't do as well as they could in the stock market is because they get greedy during bull markets and don't know when to sell. Instead, as share prices go up and up, most start to believe they can time the market top and wait to sell when they should sell on valuation.

Yes, nothing seemingly hurts more than buying shares at $25, selling at $45 and then watching the shares climb to $75. For some odd reason, investors feel upset and dumb when a scenario like this unfolds. Of course, it's never fun to leave money on the table, but how many unsuccessful investors do you think exist because they are making 25% instead of 50%? As the old adage goes, you can't go broke taking profits.

The U.S. stock market continues to make new highs with no end in sight, so it's quite easy for the human psyche to get complacent and assume that stock prices will always go up. Alas, we know how that story ends. However, there is a middle ground to not selling today but also committing yourself to selling at a higher price at a future date: Sell covered call options, or sell call options on stocks you already own.

A seller of a call options obligates himself to deliver the underlying shares at a specific price within a specific period of time. In exchange, the seller receives a premium that he keeps. By selling a call, you are basically agreeing to sell your stock at a certain price but taking the option premium as additional upside. On the other hand, if the price of the underlying stock declines, the option premium helps blunt the decline.

Earlier this week, I commented on Chipotle Mexican Grill (CMG). The shares have climbed from $250 to over $520 during the past 52 weeks. CMG is an excellent company but the valuation is certainly full, to say the least. Heading into the end of year, you can sell the January 2014 $540 calls for approximately $15 a share (note, however, that one option contract covers 100 shares). Selling this call obligates you to sell CMG shares for $540 by Jan. 18, 2014. If CMG shares trade for $540 by then, you will have to sell them but also keep the option premium so you pocket $540 plus $15 minus commissions. If CMG shares don't touch $540 by expiry, you keep the shares and the option premium.

The option premium of $15 equals 2.8% of Chipotle's current price of approximately $525. That's the effective yield of selling this option. Since you would earn that in about 10 weeks' time, the annualized yield comes to approximately 15%. The obvious risks are that CMG shares could zoom past $555, the price at which you are effectively selling the stock since you sell at $540 plus the option premium. But again, there is no economic harm when you sell at $555 and the stock goes to $600. There is harm however, in not selling and watching the price drop. If shares of CMG fall below $510, you are better off having sold the stock to begin with -- but at least the option premium helped blunt the effect.

In addition to CMG, widely held names such as Amazon (AMZN), Netflix (NFLX), Facebook (FB), Google (GOOG), Costco (COST), Procter & Gamble (PG) and many others are perfectly positioned for the intelligent use of covered call options.

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