Covered Calls: The “Safe” Income Generator
by Investment U Research
An Investment U White Paper Report
Do you own stocks? There’s a way to potentially make them even more profitable.
Here’s what ordinary investors do: Buy shares and wait for them to go up.
Here’s what smart investors do: Buy shares, and then sell call options against every 100 shares they own.
Why do they do this? There are several reasons, but arguably the most compelling is that it allows them to earn passive income from stocks they already own. That’s right… you can earn passive income just because you have some shares sitting in your account.
The strategy is something that any investor can do. It’s very easy.
And right off the bat, there are five benefits…
- You generate income
- You mitigate risk
- You lower the original price you paid for the shares
- You can use covered calls in any market
- The strategy beats the market averages over time
Here’s how it works…
Got 100 Shares? Sell A Call
The first step to trading covered calls is to shake off the notion that options are risky investments – or at least riskier than others. That’s not necessarily the case.
In fact, while you will need to get approval to trade them from your brokerage, covered calls are a great place to start, since they’re at the simple end of the options chain. And played the right way, it’s a conservative strategy, because the shares act as “collateral” for your options. They’re known as “covered” calls because you already own the shares – hence the collateral.
In order to execute a covered call trade, you must first own at least 100 shares of a given stock. That’s because one option contract is made up of 100 shares.
Then you just sell call options against your long stock position.
Why Trade Covered Calls?
By selling call options against your shares, other investors will pay you cash today in exchange for the opportunity to take your shares from you for a pre-determined price (this is known as the “strike price”) over a pre-determined amount of time (known as the “options expiration date”).
So why would you do this?
Simply put, because you have three different ways to make money:
- From the share price appreciation
- From the rise in the options price
- From the premium you receive from the call option buyer (This is yours to keep, no matter what happens, and also lowers your overall cost on the shares you bought)
So selling covered calls is a great way to earn some extra income on your stocks without actually having to sell them. But when you do, you have to make a decision about what strike price to use. Here’s how you do that…
Let’s say you buy shares of Bert’s Bottles for $40.
When you do, you factor in the stock’s fair value at $25 – the price at which you’d be more comfortable owning the shares. And if you can’t, you at least want to get paid for trying. This makes it a good candidate to sell an in-the-money call option against your shares, which you do like this…
- You buy 100 shares of Bert’s at $40 each.
- After looking at the company’s options chain for the next six months, you settle on the $25 call option, trading for $20. Because the option’s strike price is lower than the current share price, it’s called “in-the-money.”
That $20 (which is really $2,000, given that there are 100 shares in an options contract) goes straight into your trading account and is part of your return. Because Bert’s is trading at $40, that $25 option has an intrinsic value of $15 ($40 minus $25 = $15). The extra $5 is for time and risk. Your potential profit is the difference between the Strike Price and your cost – which, in this case, is $5 ($25 minus $20 (your cost) = $5).
Your return is calculated as follows: $40(stock price) minus $20 (premium received) = $20 (your cost). $25 (strike price) minus $20 = $5. $5 divided by $20 (cost) = 25%.
- If Bert’s Closes Below Your $25 Strike Price By Options Expiration: You keep the shares. Your cost is $20 and you can sell the shares for more or sell more options to reduce your cost further.
- If Bert’s Closes Above $25 By Expiration: You don’t get to own Bert’s at your price, but do get to keep the 25% return from the premium.
If you’re bullish on a stock and want to keep it for the long-term, but are frustrated because it’s currently flat, the best option is to sell calls to someone at a strike price above the current share price – at a level the stock is not expected to reach by expiration. This is known as out-of-the-money call options.
Using our Bert’s example, let’s say you’ve bought the shares for $25 each, but they’ve only risen by $1 in one year. Weak!
Enter the covered call trade. Most ordinary investors don’t realize that a stocks that’s going nowhere fast can still make money. And in fact, by selling calls against it, you can…
- Gain passive income by collecting the option premium from a buyer
- Guarantee a gain by establishing a profitable sell point at which your calls will be exercised when you execute the transaction
- Reduce the price you paid for the shares and your risk
So let’s say you sell Bert’s call options against your shares at the $30 strike price, with expiration in six months time. That means if the stock moves higher than $30, you’re still obligated to sell at $30. However, given that Bert’s shares have gone nowhere since you bought them, you’d be happy to sell for $30.
You check the options chain and see that the $30 calls are selling for $1. That means for every call you sell, you’ll pocket $100 ($1 x 100 = $100). Again, that money is yours to keep, plus any stock appreciation gains.
While ordinary investors would sit in frustration, waiting and hoping for Bert’s shares to rise, smarter investors make some extra cash by being proactive. And the premium helps lower the original price you paid for the shares, too.
Be The Landlord Of Your Stocks: “Rent” Them For Extra Cash
Another way to look at covered calls is that you’re essentially “renting” your stocks and collecting extra money for them.
For example, let’s say you bought those Bert’s shares at $25. You intend to hold them for six months, and have a price target of $30. If that happens, you’d pocket a tidy 20%.
Not bad – but that’s just “normal” investing. Writing covered calls would allow you to do better.
If you sold $30 call options against your stock position, you’d receive a premium for doing so. This would not only lower the original price you paid for the shares (otherwise known as your “cost basis”), but you’d also gain share price appreciation at the same time.
When you do so, you’re obligated to sell your shares to the option buyer at the mandated $30 price, if requested. This may or may not happen, but in any event, you’re sure to receive some money for it. You’re essentially getting “rental income” on your shares. You get the rent when you sell the option.
For example, let’s say you collect $1.50 in premiums. That would cut your cost basis to $23.50. So if shares hit your $30 target, your upside then becomes $6.50 ($30 strike price minus $23.50). That’s $1.50 better than the $5 profit you’d see if you just held the shares alone. So you turn a 20% profit into a 27.6% gain.
Of course, if shares rise above $30, your upside would be limited, because you’d be obligated to sell your shares at $30. However, since that was your original price target anyway, you not only end up collecting the profit from the share price appreciation but also from the $1.50 option premium you received, too.
So what if Bert’s shares do rally and you change your mind about selling them? No problem…
The Buyback Fallback Plan
If Bert’s shares rise above $30, you have two choices…
- Let Your Shares Go: Remember, your upside profit potential is $30. That’s the price at which you have to sell, no matter how high the shares go. This is why it’s important that you select a strike price and expiration date that suits you. If you let your shares get called away, you get to keep your options premium and pocket the capital appreciation from your long stock position. Also, keep in mind that if Bert’s doesn’t rise above $30 a share by expiration, you not only get to keep the premium money but also repeat this trade month after month, with different expiration dates.
- Buy Back The Options: If you don’t want to miss out on the share price appreciation, the covered call strategy allows you to be flexible. You’d have the chance to buy back the options before expiration and keep the shares. You’re not taking a loss by doing this, because the larger profit from the shares offsets any hit you take from buying back the options.
The best outcome for you is that you’re correct in your outlook for the stock, and it doesn’t come close to $30 by expiration. At that point, the trade would simply expire and you’d get to hang onto your shares, in addition to the premium.
Use Covered Calls To Offset A Falling Stock And Hedge Your Risk
Covered calls also protect you when your stocks decline.
Simply sell a call option at a strike price where you’d be comfortable selling your shares, or at a higher level that you don’t think the stock will hit.
Let’s say you own 300 shares of a retailer, but with it not being holiday season, you think the company could endure three months of downside. While you don’t necessarily want to sell your shares, you do want to protect yourself against this scenario.
To do so, you could sell three call options against your 300 shares. If the stock is trading at $20, you could pick the $25 calls that expire in three months. For this, you’d receive a premium of $0.50 for each of your three options. That means you’d collect $150 upfront from the option buyer ($0.50 x 100 x 3 = $150). That’s yours to keep, no matter what happens.
Two Transactions In One Easy Step: The Power Of The “Buy-Write” Strategy
Up to now, we’ve talked about writing covered call options against shares that you already own. But what if you want to execute the entire transaction at the same time?
You do it through a buy-write trade.
This means you buy the shares, then write the covered calls. You just need a target price for the stock and the same for the option you’re selling against it. The price you pay is called the “net debit” once the option premium is deducted from the price of the stock. Doing so gives you two benefits:
- You enter your target prices for each part of the trade at the prices you want. This avoids “chasing” a stock and option at the outset and allows you to obtain optimum profits.
- If neither the shares nor the options that you want hit your stated price targets, you don’t get into it at all.
By using a buy-write, you also avoid the inadvisable “market order” request, where you basically tell your broker to fill you at whatever the current market rate is. Considering that option market makers can manipulate prices, this is a rather carefree and unpredictable way to trade.
The buy-write technique is also much easier than placing a “limit order,” where you’d have to set your buy price on the stock, verify that you were filled, then execute the option trade the same way, using another limit order.
Own Quality Stocks… And Get Paid For It
As you can see, compared to an investor who holds just the shares, selling covered calls gives you some valuable additional benefits.
And if used with the right stock, it’s a great way to collect regular income from your stock holdings, and reduce your net cost.
The bottom line is this: You don’t just have to let your shares sit idly in your account, waiting for them to go up in price. If you have a pre-determined sell point in mind, someone will be willing to pay you money today for the right to take your shares from you at that price.
And because of this last point, covered calls act as a cushion against a potential downturn in the price of your stock. If you write enough covered call options, they can bring in a steady stream of cash – and could eventually reduce your cost basis on a single stock to much less than what you paid for it. This means you can own shares in quality companies at your price.
Elevate yourself above the crowd and make your stocks work harder for you, turning ordinary stock holdings into dynamic income-producing vehicles.
Investment U Research