Many investors own stocks and simply hope that dividends and capital gains will be enough. The problem: hope isn't a strategy.
Studies show that most individual investors underestimate how much money they'll actually need during retirement. And I'm willing to bet... if you're being honest with yourself, you'd probably admit that you're not earning enough income.
But covered calls can help get you there.
For those who are unfamiliar, covered calls let you make a deal with other traders who want to pay you cash upfront for the opportunity to buy a stock you already own at a higher price. That money goes straight into your brokerage account. You collect the cash they pay to make the deal immediately (we like to think of this as a "bonus dividend") -- and you still get the opportunity to sell your shares for a profit down the road.
Sounds pretty good, right? Of course, there are some things you need to understand about this strategy first, and I'll get to those in a moment.
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But the nice thing about covered calls is you can use this strategy to generate income for day-to-day living costs... monthly bills... medical expenses... even have enough additional income for things you otherwise couldn't afford, like a lavish vacation.
However often you do it and however you use the income -- the power is in your hands. It's one of the most conservative ways around to generate extra income from the stocks you already own.
Just ask my colleague Amber Hestla, head of Profitable Trading's Maximum Income service. Amber and her premium readers use this entry-level options strategy to earn hundreds of dollars -- sometimes even thousands -- in extra income with each and every trade in her newsletter.
An Example Of A Covered Call Trade
A covered call strategy requires you to sell call options on a stock you just bought or already own (that's the "covered" part). When you sell call options, you can generate upfront income, also known as a premium, for every 100 shares you own.
Since you earn this income upfront, this offsets some of the downside risk in the stock -- the money you earn effectively reduces your cost basis. And because you own the shares, you still get to participate in some of the upside.
Let me give you an example of a covered call trade. (Keep in mind, this is not one of Amber's official recommendations -- I'm using this for illustrative purposes only.)
As I write this, shares of the energy refiner Phillips 66 (NYSE: PSX) are trading for about $97. Let's say you recently bought 100 shares. You could sell a call option on Phillips 66 that expires on March 22 with a strike price of $100 for about $1.30.
This means if you execute this trade, you'll earn a premium of $130 ($1.30 x 100 shares). That's a return of about 1.3% ($130/$970).
That may not sound like much, but it's also about 40% of PSX's current annual dividend yield. What's more, this trade expires on March 22, which is 28 days from now. You can then turn around and make a similar trade all over again. (Special bonus: PSX yields 3.3% right now, so you'll be collecting this, too.)
Now, as long as the stock price stays below $100 on the date the options expire, you get to keep your shares.
On the flip side, if the share price rises to $100 or above, you'll sell the shares, giving you a net profit of about 4.4% in 28 days. That's not bad for what would amount to a short-term trade.
How To Win With Covered Calls... Even When You're Wrong
Now here's where covered calls can really save your bacon. Let's say you recently bought 100 shares of Phillips 66 thinking the shares would rise. But something happens that you didn't anticipate (like an earnings miss) and the stock plunges by 5% (to $92.15).
If the stock remains below $100 by March 22, then you'll still keep the $130 per contract and continue to own the stock. In this case, you'll own PSX at a cost basis of $95.70 (Remember: you paid $97 per share, minus the $1.30 premium you received).
So what would have been a 5% loss is now only a 3.7% loss. Not bad either. That helps soften the blow a bit.
And since you had enough faith in the company to buy shares in the first place, you should be able to sleep a little better at night knowing that either the stock price will either rise or you can hold on and keep selling covered calls on the position to earn income and lower your cost basis. (Again, let's not forget those regular dividends, either, which further reduce your cost basis, and minimize losses until things turn around.)
How To Sart Using Covered Calls
In this market, where safe income is tough to find, selling covered calls on high-quality stocks could be among the best -- and easiest -- strategies available.
That's not to say covered calls are risk-free, of course. No investment is. But there's a reason sophisticated high-tech hedge funds and old-school value managers alike use covered calls... they can help you reduce risk and pay you to wait -- with stocks you already own. It's a no-brainer in a lot of ways.