Most people think investing success is a matter of finding good stocks and buying them when the odds favor a rise in the price. They buy a blue-chip stock like Procter & Gamble, Amazon, Philip Morris or MasterCard -- monitor their position closely, collect any dividends that may come in... and hope things work out.
True success, however, also involves knowing when to sell and how to use all the investment tools at your disposal to reach your goals.
While most investors have studied different methods of analyzing what stocks to buy and when, few have considered all of the possible trading tools at their disposal.
Instead, I'm interested in earning income. Now.
That may sound a little greedy, but I assure you it's not. In fact, some of the world's best money managers and hedge funds have the same goal.
One way we can achieve this is with options...
Most individual traders would probably say that options are among the riskiest investments anyone could make. They're partially right -- trading options the way most individuals do is risky. But options have been used for decades by Wall Street firms to manage risk. Today, I want to show you how to use options the way a Wall Street firm would -- as a valuable risk management and income-generating tool -- rather than the speculative way most individuals trade them.
If you've read my essays about using options for income before, you know that, according to the Chicago Mercantile Exchange, options tend to expire worthless about 82.7% of the time. That's bad news for buyers, who lose their entire investment when this happens, but it means that 82.7% of options trades were profitable for sellers.
Readers of my Maximum Income newsletter are very familiar with this stat, and they're using it to their advantage by being on the winning side of this trade -- they're sellers. Specifically, we do this by selling covered calls.
Let me explain...
Call options give the buyer the right to buy the stock that the option covers. Each option has a strike (exercise) price and expiration date. The strike price sets the level where the option becomes profitable.
If a call has a strike price of $10, the buyer will only exercise their right to buy the stock if the price is above $10 when it expires.
The expiration date defines the last day a buyer can exercise the option. Expiration dates can be as close as a few days away to as long as a few years. My Maximum Income readers and I usually use options with expiration dates within the next three months.
Sellers have an obligation to fulfill the other side of the trade if the buyer exercises the option. If you sell a call option, you will have to deliver the stock to the call buyer if the price rises above the option's strike price.
As a rule of thumb, I always sell covered calls with strike prices above the stock's current price. You get to lock in whatever upside the stock experiences from when you buy up to the strike price as a gain. The call buyer pays you upfront, known as a premium, for the right to buy your stock at that predetermined higher price.
And best of all, you can sell covered calls on a stock that you own several times a year, which means you could triple or quadruple the income you receive from the stock.
We can use this, along with our knowledge that most options expire worthless anyway, to create a high-income strategy -- the same kind used by countless successful Wall Street hedge funds and money managers.
You can even begin using this strategy on stocks you already own -- and more than likely with the broker you already use.
Once you begin using this strategy, it's easy to see the possibilities. For example, let's take a look at the blue-chip stocks I mentioned above to see how much income you could be collecting from them today.
To give you a better idea of the power of covered calls, let's take a closer look at MasterCard...
Just recently, I recommend selling March $78 calls on MasterCard for around $1.70. That means, for every 100 shares of MasterCard you either purchase or own, you collect about $170 upfront.
Buying 100 shares of MasterCard at $76.50, for example, would cost $7,650. But by collecting $170 upfront as a premium, our cost basis would be reduced to $74.80 per share ($76.50 - $1.70).
Selling this call means you will have to sell the stock at $78 if shares trade above that on March 21 (the last day these options can be traded).
Assuming MasterCard trades for $78 or less on March 21, we keep the premium and make a profit of $170 on $7,650, or 2.2%, in 43 days. That may not sound like much, but think about that for a second... If we can repeat a similar trade every 43 days, that's the same as earning an 18.9% yield on MasterCard in 12 months.
All this from a blue-chip stock that currently yields less than 1%.
If MasterCard trades above $78 on March 21, our stock will be called. In that case, we will sell the shares for $78. But you'll keep the $170 per contract.
In this case, you'll realize a profit of $3.20 per share ($78 - $74.80 cost basis), or $320 per 100 shares. This is a profit of 4.3% in 43 days, or a 36.3% annualized return.
This is just one example of the income potential covered calls give to investors. And my Maximum Income readers are using it to generate income streams worth thousands of dollars a month.