Generate High Yield With Covered Calls
Many traders buy options for the leverage they offer. Options provide a chance to achieve a higher percentage return in a shorter amount of time than you can typically accomplish with stocks.
Others sell options to increase income.
When you sell, or write, a call or put option, you receive money in return. That is called a premium.
Collect Cash by Selling a Call
A popular strategy is to sell call options against stocks you already own if you have at least 100 shares of that stock.
If you have 500 shares of Intel (NSDQ: INTC), you can sell as many as 5 call option contracts.
In essence, you are getting $1.10 per share in exchange for the right to buy the shares from you at $65 for about 4 months. This is equivalent to a yield of about 5.5%.
Obviously, option premiums aren’t dividends, but in effect they work the same as dividends in that you are getting cash.
Comparing the Yields
To calculate a stock’s current dividend yield, you annualize the dividend and divide it by the stock price.
For Intel, it’s trading at about $60, and it paid $0.315 per share in its latest quarter. Thus, its yield is 2.1%: $0.315 x 4 ÷ $60 = 2.1%.
Remember where we said that the April call is equivalent to a 5.5% yield? Let’s work out the calculation.
Since you are getting $1.10 for being in the call contract for 4 months, to annualize you will need to multiply $1.10 by 3. Thus, the yield is $1.10 x 3 ÷ $60 = 5.5%.
Put in another way, by selling this call, you are getting a yield that’s more than twice your dividend yield!
(To be more exact, the option contract duration is really 3.5 months, so your actual annual yield is a bit better than 5.5%, but to keep things simple let’s just call it 3 months.)
You Could Lose Your Shares
Now, the drawback is that if INTC rallies to more than $65 by the expiration date, your shares will be called away. And if INTC rallied a lot higher than $65, you would end up losing money on the trade.
For example, if INTC ended up at $70 and your shares were called away at $65, you would lose $3.90 per share on the trade. This is because if you hadn’t sold the call option, you could have sold the shares at $70. Instead, you sold at $65. So you lost out on $5 per share, and the $1.10 premium reduces the net loss to $3.90.
To reduce the chances of seller’s remorse, it helps to pick a strike price at which you would be comfortable selling anyway.
The ideal scenario for you would be if INTC moved up in price but not high enough for the option to exercise. Let’s say INTC ended up at $64, then you would enjoy $4 a share in unrealized gains plus you just pocket the option premium, and you are free to sell another call if you want to and keep collecting the premiums.
If you want to keep your INTC shares, you could just buy an equal number of the same call option contract to close your position. Your gain or loss would be the difference between the premium you received and the premium you paid.
You could also just write an option against some of your shares. In the INTC example, if you wrote just 3 contracts, only 300 of your INTC shares would be at risk of being called away.
To minimize the chances of losing your shares, you can pick a strike price that is far out of the money. The drawback to this is that the premium will be lower.
If you expect the market to decline, however, selling a call with a strike price that’s closer to the money for a higher premium may make more sense.
Indeed, that’s the beauty of options. They offer considerable flexibility and versatility.
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