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How to use covered calls to generate recurring income.
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Stock Options
If you own stocks or ETFs and you're not writing call options against them then you are leaving money on the table every month.
A strong statement but one that we at Born To Sell believe in (if you can't answer "What is a call option?" or "What is a covered call?" then please visit the covered call tutorial).
Let's imagine that you are a careful investor and have spent some time building up a diversified portfolio of solid stocks and ETFs. Maybe they pay dividends so you are enjoying a little income from your portfolio, too.
That's a great start. But you could be doing better.
How much better? Probably at least 4-6%/year better, and perhaps more depending on how aggressive you are with your stock options strike prices.
How? By writing out-of-the-money (OTM) calls against your portfolio each month. Because they are OTM you still have room for upside potential, in addition to receiving the call premium each month.
Let's look at an example $25K portfolio. Suppose you own the following:
Currently this portfolio pays about $785/year in dividends (3.1%).
Now, imagine you are willing to sell any of these stocks if they rise by 5% or more in a 30 day period, i.e. you write call options (stock options) against all of them that are about 5% out-of-the-money. How much call premium could you make in a month? (prices are as of August 16, 2010)
- INTC (@ 19.47) write the Sep 21 (7.8% OTM) for 16 cents, receive $48
- MRK (@ 34.97) write the Sep 37 (5.8% OTM) for 20 cents, receive $40
- BAC (@ 13.19) write the Sep 14 (6.1% OTM) for 24 cents, receive $96
- XOM (@ 59.88) write the Sep 62.50 (4.4% OTM) for 48 cents, receive $48
- XLY (@ 30.74) write the Sep 32 (4.1% OTM) for 38 cents, receive $76
So, you could receive $308 in call premium today; minus commissions, which if you trade at a discount broker should be less than $5/trade, so let's call it $280 after commissions.
That's $280 in premium for 5 weeks. You can repeat this process every month. Some months you may get a bit more, and other months a bit less. But even if you average only $200/month if you do it 12x per year then that's $2400/year in extra call premium you receive (that you're not getting today), or roughly 3x the current dividend yield for this example portfolio. Remember, this is a $25K portfolio; so in this example the $2400 represents over 9%/year in call premium income.
Now, if any of those stocks finish above the strike price on expiration day (meaning they rise by more than about 5% in 5 weeks) then you can either buy the options back (potentially at a loss, depending how much the stock has gone up) or let them get called away (in which case you've made about 5% on the underlying stock sale, plus the call premium you received).
If you think your stocks might shoot up by 5% in a month then you can set the stock options strike prices farther out - maybe 10% out-of-the-money. You will get less call premium but also have less of a chance that they will get called away (and if they do you've made 10% on the underlying stock in 5 weeks).
The covered call strategy works particularly well in a sideways moving market. It probably won't yield the best results in a strong bull market, but it will yield better results than a buy-and-hold strategy in a sideways or bear market. The important point is that you've already made the decision to take the equity risk... after all these are your existing stocks we're talking about. All we're suggesting is that you let time work for you and milk your existing stocks for extra income each month.
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.