Let’s say you own stock in a company that you like, but you would like it even more if it paid you extra income. Additionally, you might like to reduce your risk in owning the stock. You accomplish both by using a strategy called the “Covered Call Writing Strategy.” Simply put, this is selling the right to buy your stock to the market. The buyer (who is paying you) is the gambler. He/She is betting the stock will go up by a certain amount in a specified time.
The advantages, again, are increased income and decreased risk. The increased income comes from selling (“writing”) a “call” option on your stock. This strategy is conservative and fairly simple. For every 100 shares of stock, you can sell one call option. So, on your 500 shares of ABC stock, for example, you could sell five contrasts. You pick two important variables: the strike price and the expectation date. The strike price is the price you [should be] willing to sell your stock; aka having it “called” away from you. You are obligated to sell your stock at the strike price if called. The expiration date is when the option expires.
Here’s how it works using the hypothetical ABC stock example. Suppose ABC stock is currently trading near $81, you could sell a call option with an $85 “strike” and a December “expiration,” expiring in two months. At this time, the market for that call option is $1.50 per share. Remember, you are selling call option contracts, each one representing 100 shares of your stock. So, in this example you would collect $150 per contract, which is $750 from covering all of your 500 ABC shares. This option income is called the option “premium.”
In this example, the option income equates to an annualized return of 11.11% (6 x (1.50/81). I call this “manufacturing dividends.” If done just once a year with a dividend paying stock, you would get paid five times per year; four dividends and one option premium. Your frequency of receiving cash flow from your stock could increase to 16 times, 12 monthly option premiums plus four quarterly dividends. That’s clearly an increase in stock investment income.
How is your risk decreased? By lowering you stock cost basis by the amount of option premiums you receive. The stock can fall below your original cost basis equal to the option premiums you collected before you have a loss on your investment. However, while you have reduced your downside risk, you have also limited your upside return. This is the “opportunity cost” of the covered call writing strategy (notice I don’t call it risk). Any time your stock rises above your strike price, you could have it called away. That results in a forced sell of your stock. In the ABC example, you may have your stock sold at the $85 strike in the next two months. While you made $5.50 per share ($4 gain from 81 to 85, plus the $1.50 of option premium), which is nearly 7%, you would have missed out on gains over $85. So, if ABC unexpectedly jumped to $105, you would get only $85. Less money was made on the investment; however, money was still made. Not a situation of principal risk, but rather of missed opportunity.
The 9% Solution
When you consider owning a stock that pays a modest dividend, provides a small capital gain, and generates additional income from option premiums, you can see why I call this, “The 9% Solution.” Making $9 on a $100 stock in a year from all three positive inputs is realistic. As mentioned above, the covered call strategy is conservative. Aside from the opportunity loss, there is no principal risk with this strategy. One must never forget, though, that there is always risk of loss of money in a stock investment; regardless of option income that is received.
Not for all investors. Not for all stocks.
We can all think about those great growth stocks, especially now, that seem to just go up and up. The likes of the “FAANG” stocks (Facebook, Apple, Amazon, Netflix, and Google) have been remarkable investments over the last few years that have provided market-crushing returns. They would not have been the ideal type of stock for this strategy. I say, “Let growth grow and cover income stocks for more income.” The best candidates for this strategy are moderate-to-high dividend paying stocks that typically are unlikely to shoot up in price in the short term.
There, of course, are exceptions to these general rules of thumb. The more risk averse, conservative investor is best suited for the covered call strategy. It is not a wise approach for all investors, though. Younger, growth-oriented investors with lots of time on their side should pass. For the rest of us, the covered call writing strategy is a proven, conservative way to approach double-digit returns from stocks year in and year out.
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