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How to use covered calls to generate recurring income.
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Successful Income Investing
Successful income investing involves putting together a collection of assets that generates the highest possible income at the lowest possible risk.
The most common income producing assets classes are:
- stocks (dividends)
- bonds (interest)
- real estate (rent)
- other investments (limited partnerships) that produce income
A properly constructed income portfolio is diversified across non-correlated asset types so that when one goes out of favor (or stops paying) the others are still producing income as planned. The exact allocation across the various income producing asset classes depends on many factors: size of portfolio, your age, your risk tolerance, your income goal, how long you can tie your money up for, etc. Since we are mostly concerned with stocks here, let's take a look at how you can use the stock portion of your income portfolio to generate income.
Dividend Income
The most obvious income you can derive from stocks is dividends. Not all companies pay dividends but usually the more established, profitable ones do. Having a portfolio of stable, dividend paying companies is a reasonable place to start if you are investing for income.
A good goal is to choose companies that pay at least 3% per year in annual dividend.
Option Income
Another source of income from stocks comes from call option premium. By selling call options against stocks you own, you can generate recurring monthly income. Like many income investing strategies, covered calls are best used over a long period of time. It's not get-rich-quick, but it can be get rich slowly (or even just generate enough income to cover your monthly expenses).
Many investors find they can generate 6% to 10% per year in option premium income by selling out of the money calls on their large cap dividend paying blue chip stocks. Combine this with a 3% dividend and you're looking at an asset that can generate 9% to 13% per year (and because they are out of the money options you still have some upside potential on the underlying stocks).
Vary Your Time Horizon
Much the same way you'd create a bond ladder with various maturities, when writing a portfolio of covered calls you may want to stagger your expiration dates across a few months, with a possible bias towards the near term (since time decay is better for the option writer on the shorter duration options). The longer term options will have more time premium (and possibly more intrinsic value (i.e. downside protection) if you are writing in-the-money options) and should insulate you a bit from daily or weekly changes in the price of the underlying securities.
Equity Risk
The negative side of using stocks as income producing assets is that they can go down in value. You have equity risk. While the same is true for other income producing asset classes (i.e. real estate can go down in value, and bonds will go down in value as interest rates rise; although if you hold them to maturity and they don't default you may not care about their value going up and down) it is true that historically stocks have been more volatile. Of course, this volatility is also what causes better yield through juicy option premiums.
You can reduce equity risk somewhat by selling in-the-money calls. They have greater downside protection due to their intrinsic value.
Diversify
Owning 10 bank stocks may mean that you are diversified across the banking sector but you are hardly diversified across the stock universe. One key to successful income investing is to pay attention to position sizing and diversification. Even if you hate tech, you should have a tech stock in your portfolio (even if the dividend yield is low; the call premiums are likely to make up for that). Likewise, own some healthcare, some financials, some consumer stocks, some commodity related stocks, some foreign ETFs, etc.
There's usually a bull market somewhere and good diversification will most likely let you capture some of it. But the goal when investing for income is capital preservation combined with reasonable current income. Non-diversified portfolios run a much higher risk of significant principal reduction.
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.