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With the S&P bouncing back 17% since its low point of 1099.23 on Oct. 3rd through Oct. 27th, some investors are nervously wondering how long the current rally can last. If you want to participate in the rally AND have some protection, selling covered calls and/or cash secured put options may interest you. The key is using these strategies with dividend stocks that you're comfortable owning. As an example, we'll use Caterpillar, (NYSE:CAT), which has been one of the best stocks to buy in this rally, as it has risen more than any other Dow dividend stocks over the past trading month.

Selling Covered Calls to hedge your gains: (There are further details on this and over 30 other high yield covered call trades in our Covered Calls Table.)

If you'd had the good fortune to buy CAT on Oct. 3rd, when it began to rise from its year-to-date low of $70.55, all the way to $96.33, (up 36.5% through Oct. 27th), you could hedge over a third of your gain by selling covered call options. Here's how it works:

(By selling covered calls, you're committing to sell the underlying shares at whatever strike price you sell the call option at. Each option contract corresponds to 100 shares of the underlying stock, so we'll use 100 shares of CAT to keep this example clear.)

1. Underlying stock cost/share: $70.55

2. 10/27/11 closing cost/share: $96.33

3. Go to the Options Chain for CAT, and open the May 2012 options. There are call options at a strike price of $97.50, which are selling for $9.55, roughly 37% of the Oct. gains that CAT has made. The idea here is to sell call options above the current strike price, which are "out of the money." This allows you some additional potential price gain if the shares get assigned:

Click to enlarge

4. You'd "sell to open" one $97.50 call option contract for each 100 shares of CAT that you own. This obligates you to potentially have to sell your shares of CAT at $97.50 up until the expiration date of May 19, 2012. (U.S. options expire on the 3rd Friday of the month, and are usually deemed expired or assigned during the next two days, Saturday or Sunday, by your broker.) You'd receive $955.00 for each contract you sell. This money is usually credited to your account by online brokers the same day, or within three business days of the trade at the latest. So you get paid right away, as opposed to waiting for the quarterly dividend payout.

Your breakeven is $60.08, your initial cost of $70.55/share, minus the call option sale of $9.55/share, and minus the $.92/share in dividends you'll qualify for prior to expiration.

CAT-CALLS

Potential Outcomes For Covered Calls:

1. CAT doesn't rise above $97.50 - The $97.50 call options expire worthless, leaving you with your $955.00 option annualized static yield of 24.46%, plus the two quarterly dividends totaling $92.00/100 shares, and you still own your shares.

2. CAT rises above $97.5o, enough for your shares to be assigned/sold away from you at $97.50/share. In addition to the call option sale money of $9.55/share, your profit also includes $26.95/share, (the difference between the $97.50 and your $70.55 cost), and the two quarterly dividends, for a total annualized assigned yield of 95.84%. Please note: this is an extremely high annualized assigned yield because of the big price gain involved. If you'd bought CAT at $96.33 on 10/27/11, and it was assigned/sold at expiration in May, your total assigned yield would be 21.96%, which is still very attractive.

In scenario #2, it depends upon whether or not there are any call option buyers who paid a price that's lower than the difference between the $97.50 strike price you sold the calls at, and CAT's price near or at expiration. If it's advantageous, these call buyers would exercise the call option to buy your shares at $97.50. (In general, option buyers tend to exercise call options to buy a stock as it gets closer to the expiration date.)

3. CAT rises above $97.50, but not enough for your shares to get assigned/sold away from you. In this scenario, it depends upon whether or not there are any call option buyers who paid a price that's lower than the difference between the $97.50 strike price you sold the calls at, and CAT's price near or at expiration. The outcome is the same as scenario #1.

Selling Cash Secured Puts: (You can find more details on this and over 30 other high yielding cash secured put trades in our Cash Secured Puts Table.)

Maybe you missed the big October move for CAT, and you'd still like to own it, but you don't want to pay the current price. Selling cash secured puts at a strike price below the stock's current price also offers you a lower break-even price than the current stock price, and immediate income. However, unlike selling covered calls, you don't collect any dividends. We'll use the same May 2012 expiration month for this put option example.

Since CAT closed at $96.33, let's sell one $95.00 put option, just "out of the money." This obligates you to potentially have to buy 100 shares of CAT at $95.00/share near or on the expiration date of May 19, 2012. Your broker will reserve/hold $9,500.00 in your account when you sell this $95.00 put, which is the "cash reserved" part of the equation.

1. You'd "sell to open" one put option contract for every 100 shares of CAT that you want to own. You receive $10.15/share, or a total of $1015.00 for each option contract sold. Your breakeven is $84.85, which equals the $95.00 strike price, minus the put price of $10.15 that you sold for.

CAT-PUTS

Potential Outcomes For Selling Cash Secured Puts:

1. CAT doesn't fall below $95.00 - The $95.00 put options expire worthless, leaving you with your $1015.00 profit, a 19.31% annualized yield. Your broker releases the $9,500.00 cash reserves in your account.

2. CAT falls below $95.00, but is still above your breakeven - If CAT only falls $5.00, for example, to $90.00, you still may be assigned/sold the 100 shares at $90.00, if it's advantageous for a put buyer to exercise his put option.

However, since your $84.85 breakeven price is still lower than CAT's $90.00 price, you could sell these 100 assigned shares and still turn a $5.15/share profit, although it'd be a smaller one than your initial put profit. Or, you might choose to hold the shares for future price appreciation and dividend income.

3. CAT falls below your breakeven - You can "retreat" from an underwater sold put position at any time before expiration by "buying to close" the sold puts, which closes out the position, and "selling to open" a new put position, at a lower strike price, and/or at a different expiration month. Generally, the further out in time you sell options, the higher the premiums are, so there's a chance of recouping a loss by selling longer-dated options. A good idea is to keep a spreadsheet with your breakeven price vs. the current price of the stock to monitor your position. This spread will be different than the price you sold the option for and the option's current price.

Disclaimer: This article is written for informational purposes only and isn’t intended as investment advice.

Disclosure:: I am long CAT by being short CAT put options.

Source: How To Earn A 20% Yield By Hedging Dow Dividend Stocks