Do you have a stock position that you have owned for a long time? Maybe it's a position that you inherited, or one that was given to you years ago. Maybe it is company stock that you methodically accumulated as an employee.
But what are you giving up by holding on to this stock? Is it really the best investment that you can make with your capital? Are you missing out on an opportunity to make more money by sitting on this long-term position?
Now, before you quit reading, let me tell you that I'm not suggesting you sell your long-term position. You have your reasons for holding this position and I respect that. But what I am suggesting is that you consider a strategy to help you create additional income from your long-term position.
Case Study: A 20-Year Investment
I once worked for a hedge fund manager named John who held a large block of company stock in his personal portfolio. This stock had sentimental value to him because he received the stock when the company first went public, more than 20 years before.
While John left the company to start his own hedge fund boutique, he still believed in the company and wanted to hold his block of stock indefinitely. Over the years, this stock had appreciated quite nicely, well above John's cost basis, which was very near zero adjusted for splits.
John had no intention of selling his stock, but he was a wise trader. He knew that he could use this stock as an asset to generate additional income. And so, without selling a single share of his favorite stock, he booked thousands of dollars of income in his personal account by using the strategy I am about to show you.
Selling Calls Against Your Long-Term Position
Creating income from an existing stock position is fairly easy. You simply sell call options against your existing stock, and you get to keep the premium for selling those contracts. This is known as a covered call strategy.
Selling a call option obligates us to sell stock at a specific price (the strike price) when the option contracts expire assuming that the stock is trading above this strike price on the expiration date.
For example, you may own a stock that is trading at $52.50, and you might sell calls that expire in a few weeks with a $55 strike price. Selling one contract obligates us to sell 100 shares of stock if the stock trades above $55 when the contracts expire.
If the stock stays below $55, we simply get to keep the money that we received for selling the call contract. This is how we generate income in our account -- and depending on how often you sell these call options and how much stock you own, you can generate a lot of income.
As long as the stock stays below our strike price, the principle is simple: Just collect your income and then repeat when the calls expire.
But what happens when the stock climbs above the strike price? Do we have to sell our prized stock? Do we recognize a large tax liability? After all, the whole point of this strategy is to keep the stock that we own for the long run.
Fortunately, there are two different tactics you can use to keep your long-term holding and still benefit from the covered call income.
Adjusting For A Rise In The Stock Price
If the stock trades above our strike price, the easiest solution is to buy back the call option contract. These contracts trade on an exchange and you can easily close your option position by "buying to close" the same option contract.
But does this mean that we realize a loss on the option contract? Not necessarily.
Using the example that we started with, let's assume that you sold the call options with a $55 strike price and you received $2 per share for this contract. Now the stock has traded up to $56 and we are just days away from expiration.
In this case, you would likely be able to buy back the contracts for a price slightly above $1, maybe $1.25. Call option prices have a tendency to decline because of "time decay" as they near expiration. When there is less time for the stock to move before expiration, the call options naturally drift toward their intrinsic value, or the amount that they are "in the money" -- in this case, $1 per share.
Even if the stock does rally significantly and causes you to realize a loss on the option trade, remember that you own the underlying stock. So your net worth is actually increasing by a larger dollar amount because the value of your stock is rising.
A second tactic you can use when the stock moves above your strike price is to buy more shares of the underlying stock, and then use your new shares to meet your obligation.
Again using the example we started with, assuming the stock rallies to $56, we could buy 100 shares of stock for every call option that we sold. Then, when the calls are assigned (and we are obligated to sell 100 shares at $55), we instruct our broker to sell the new shares to meet this obligation.
In this case, even though we are buying stock at $56 in order to deliver for a price of $55, we are still making money on the overall trade. This is because we originally sold the call contract for $2 per share, netting us a dollar per share in total profit.
No Such Thing as a 'Free Lunch'
There is one thing that I want to make clear when explaining this strategy. As my mom used to tell me (and any number of economists will tell you), "There's no such thing as a free lunch." And when we're investing, there's no such thing as "free income."
When we use this covered call strategy, we are creating income from a position that we already own in our account. But in order to receive this income, we're giving up something in return.
With this strategy, we are giving up the potential to realize huge profits if the stock trades sharply higher. This is because, by selling the call options, we are obligating ourselves to sell the stock at a particular price. Using our example, if the stock rallied to $95 in a week's time, we would miss a large part of this move because the losses from the call option would also be large.
To be clear, we would still realize some profits. But we would be giving up a large part of our potential gain.
Action to Take --> So, with this in mind, I would recommend using this strategy for long-term investments that are relatively slow-moving. I'm talking about companies that are solid and are growing, but are unlikely to double in price because of some major catalyst.
This article was originally published at ProfitableTrading.com:
Book Income From Your Favorite Stocks Without Selling a Single Share