Covered Calls 101, An Easy Way To Earn More Income, When This Works Best…
There are several compelling reasons to sell stocks. Yet, there are just as many strong arguments in favor of buying. The market, after all, is always a tug-of-war between bulls and bears.
Sometimes, neither will gain the upper hand, leaving the broader market drifting. There will certainly be volatile day-to-day price swings, but the larger trend could be sideways — what technical analysts call a “range-bound” market.
That’s not necessarily the worst thing. Even if the wind goes out of the market’s sails, dividend income can still put cash in your pocket each month and propel your portfolio. But one strategy in particular is well-suited to deliver outsized gains in this type of environment.
I’m talking about writing covered call options. This is a great way to generate extra income on stocks you own — on top of any regular dividends.
Some people believe that options are inherently risky and speculative. And indeed, they can be. But this tactic reduces risk and is even suitable inside IRA retirement accounts.
Let me explain…
Covered Calls 101
By selling a call option, you are granting somebody else the right (but not the obligation) to purchase a stock from you at a pre-determined price (the strike price) before a specified maturity date. In return, you receive an upfront cash payment called a premium.
I’ll use an example from one of our former holdings over at High-Yield Investing.
As I write this, CME Group (NYSE: CME) trades at about $207 per share. There is a call option with a strike price of $220 that expires in December. It trades for a premium of about $2.30. Each contract involves 100 shares, so selling one of these calls would net me $230 in immediate income ($2.30 x 100).
I get to keep that money regardless of what happens to the stock. Let’s say the shares fail to reach $220 before the expiration date. Then, I simply pocket an extra $230 — adding it to the dividends I will collect over the period.
What’s the catch? In exchange for the income, I would have to forgo any upside above and beyond the strike price. Suppose the shares rally sharply to $230. Then, the call option would be exercised. I would have to sell my shares to the buyer at $230, giving up any further appreciation.
Still, there are worse things than watching a stock you own climb from $207 to $230. That’s a gain of $13 per share (or $1,300 total), which, added to the premium income, would give me a total gain of $1,530. That’s a total return of about 7.4% in three months. Not bad.
What if the shares drop in value between now and December? Well, I still get $230 to help cushion the decline. That’s compared to zero for just holding the stock without any option writing.
When This Strategy Works Best
You can see how this technique would be especially useful in a flat or declining market.
Let’s say you’re a long-term holder of a stock but see little reason why the stock should surge in the short term. You can pick a call option with a good chance of expiring worthless and still earn a little income on the side. If everything works out, you will still get to keep your shares. This means you can always sell another option and earn another premium. And so on…
Using call options, you get paid to wait while the stock (or the overall market) is stuck in the doldrums.
The premium income earned from this strategy can add up significantly. The proceeds supplement ordinary dividends, giving fund holders a larger income stream — even when the market is neutral.
Now, while we don’t dabble in options over at High-Yield Investing, a number of dividend-oriented funds employ this same strategy — but on a larger scale, multiplied by thousands or even millions of shares.
Over the years, I’ve featured a few of these funds for my premium readers. The Nuveen Dow 30 Dynamic Overwrite (NYSE: DIAX) and PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP) are notable candidates worth considering.
Keep in mind options prices are a function of market volatility. Traders are willing to pay more (so sellers collect more) when turbulence occurs. By its nature, covered call writing limits upside potential in exchange for additional income and downside protection. So it stands to reason that these funds (also called buy-write funds) will lag the S&P in runaway bull markets. But they shine in uncertain conditions and can boost income when stocks aren’t going anywhere.
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