If you’re a buy-and-hold investor with at least 100 shares of a particular stock, you could be generating extra income with little effort on your part. No, I’m not referring to dividends. Selling covered calls is a low risk options strategy that allows you to collect a premium for writing calls while you still own the stock. You’ve already made of the difficult decision of what stock to buy and at what price – selling the call is the easy part. Only a fraction of investors are familiar with this investment strategy and even fewer take advantage of it.
Not too long ago, I wrote about 8 ways to generate income while interest rates are terrible. This investment strategy made the list because the consistent return can be a great way to make some extra money. As I’ll talk about below, combining covered calls with a dividend will produce even more cash and your returns could easily be in the double digits.
COVERED CALLS DEFINED
To provide a quick recap of my explanation of options – calls give the holder the right to buy a stock at a set price called the strike price.
The terms covered and naked may seem foreign when referencing investing, but the concept is simple. A covered position means that you have the position to deliver and a position is naked when you do not. If I sell to someone else the right to buy my stock, owning the stock means that I’m covered in the event that I have to sell it.
The great thing about selling options is that it can be successful in a negative, positive or flat market. You’ll always receive money for selling the call, but how much you can sell it for depends on the strike price and duration. If the stock is trading at $50, you can sell $55 calls and if the stock is quoting $25, you can sell calls with a strike of $30. Over time, the effect will be a lower cost basis, much in the same way a dividend affects your profit and loss.
As I mentioned previously, you can sell a call against a stock you own and still receive the dividend. When a stock pays a dividend, the price of the stock will be reduced by that amount that is paid. Because you are short the call (sold it), you make money as the price of the stock goes down. The downward move in stock price is offset by the dividend received and you generate a gain by the reduction of the option price.
Lets take a look at the performance of a stock over a one year period without selling calls vs. the same position combining options. Seadrill, Ltd. (SDRL) was trading at $33.92 on 12/31/10 and closed at $33.18 on 12/31/11. Had you held the stock during that period, you would be down $0.74 or 2%. Over the same period, the stock paid a total of $2.41 in dividends which helped to lower the cost basis. Without the dividend, the total loss would be $3.15 ($33.92 – 30.77) or 9%. This stock has a high dividend yield and you can see how that helps negate your losses.
Now, let’s take a look at the same investment while selling covered calls every four months against the 100 shares of SDRL that we own. Calls that expire four months out and are 10% out of the money, are currently selling for approximately $0.55. Selling 100 contracts against 100 shares will result in $55. Of course the more shares you have, the more contracts you can sell. In addition, you can sell calls that expire during the current week or even calls that expire in three years. The longer the duration, the more you will receive, but you won’t be able to sell your stock until you cover the option or it expires.
With the absence of calls, our loss was $0.74 during the year 2011. Now, if we add the premium for selling the calls three times during the year (4 month expiration), the result is a profit of $0.91 (-0.74+.55+.55+.55). As long as the stock doesn’t rise above your stock price and sold to the other party, you can continue to sell calls every time the current ones expire.
The majority of investors are intimidated by options because they’ve heard that the risks are very high. While options can indeed be risky, selling covered calls actually lowers your downside risk. That means that holding the stock alone has a greater inherent risk than selling the call against it.
Why does a call lower your risk? By definition, a call gives you the right to buy a stock at a set price, so as that stock decreases in value, the call will also lose worth. Since you sold it and it is now worth less, you have made the difference if you were to buy it back. A stock and a covered (short) call always move in opposite directions, which means the declining value of the call will always offset the loss in share price of the stock.
Upside risk is another factor you should be aware of. The owner of the call you sold has the option to buy your stock at the strike price. Whatever the reason, if the stock appreciates above the strike, the other party can exercise their right and buy your stock. For example, if you own a stock at $50 and sell a $55 call and that stock soars to $100 before the option expires, your upside gain is capped at $55.
HOW TO TRADE
So, I’ve convinced you that covered call writing is for you and you want to know what the next step is? Simply contact your broker and fill out an options application. In less than a day, your account should be set up and ready to start generating that extra income.
READERS: Do you sell covered calls against the stocks you own? If you don’t, what is stopping you?
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