The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
by Karim Rahemtulla, Investment U’s Options Expert
Tuesday, October 26, 2010: Issue #1374
Two weeks ago, I kicked off a three-part mini-series, which addresses how to get three crucial elements into your investment portfolio: Safety, income and growth.
We’ve already tackled the safety aspect, so now we’re going to move on to ways that can help you beef up the income-generating side.
And that’s more important than ever when you consider this:
While money in the bank is safe, it’s not making you any money. In fact, you’re most likely losing money these days, as the Federal Reserve has driven real interest rates to zero.
And if you’re making 0.25% in a money market account, you’re actually losing money, as the inflation rate is higher than 1%, regardless of what the government puts out.
However, there are ways to combat this income drain…
A Quartet of Income-Producing Strategies
Let me start by telling you how I divide up my personal portfolio. It’s split into four main investment categories, in addition to cash that I keep in reserve to buy into special or unpredictable opportunities. Those categories are:
- Dividend-paying stocks.
- LEAP options: These are long-term options that allow you to capture the momentum and upside or downside of stocks – and do so with less than 20% of your capital at risk.
- Put-selling: Selling put options allows you to buy stocks at the price you want – a sizeable discount to the current share price – or get paid for trying.
- Covered calls: You can generate passive income for your portfolio by selling call options against shares that you already own.
And it’s this last category that we’re going to focus on today…
The Breakdown of the Covered Call Strategy
When many investors buy shares of a certain company, they’re usually stuck with just a couple of options: Hold the shares for either capital gains or dividends.
Many ordinary investors, that is.
But there’s an easy way to kick your income up a notch. By using call options, you can actually generate income from a stock position that will usually far exceed the returns from cash. Here’s how the covered call strategy works:
- Buy Shares: Let’s say you own 1,000 shares of XYZ Corp., for which you paid $20 a share.
- Pick Price Target: Your first step is to pick a 12-month price target for the shares (you can use shorter time frames if you wish). In this case, let’s go for $24 – a 20% return.
- Select Options: Pull up the company’s options chain (a listing of all the options available) and select a call option strike price (the price at which you must either buy or sell a particular stock) that is closest to your target price. In this example, it would be $25. This is $1 above the price target, so if the shares are called away (i.e. they close above $25 at or before options expiration and you receive $25 per share), you receive your target price or more.
- Simple Math: The 12-month call option with the $25 strike is priced at $2 on the bid and $2.25 on the offer. This means that if you want to sell the option, you get $2 per contract and if you want to buy it, you pay $2.25. Each contract represents 100 underlying shares.
- Sell… Cover… Collect: In this case, we’re selling options. So if you own 1,000 shares, you can sell 10 contracts. And by selling 10 contracts of the $25 calls for $2 per contract, you’ll generate $2,000 in cash – $2,000 worth of income that you didn’t have before and which is yours to keep no matter what.
- Reduce Risk: An additional benefit is that this strategy reduces the price you paid from $20 per share to $18 ($20 minus the $2 premium received from selling the calls) – and hence your risk. So not only do you get income, you get some safety, too.
- Profit: If the stock closes at $25 by the time the options expire, your potential return bounces from 25% to 38% ($25 strike price minus $18 cost = $7. Then $7 dividend by $18 = 38%).
Covered Calls: Killing Two Birds with One Stone
By using this strategy, you accomplish two objectives…
- You reduce your cost and enhance your safety.
- You generate income.
And you can either apply covered call investing to existing share positions in your portfolio or new positions, too.
So take a look at your stock positions, set target prices at which you’d be happy selling your shares, and start selling options to generate some income in this negative income environment.
And remember, you can reverse a covered call position at any time by buying back the option and selling the shares.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.