Selling Covered Calls To Boost Your Income
I had a recent exchange with a reader, who said he simply hadn’t save enough to retire. He told me that the ~4% income from his portfolio just wasn’t enough to pay the bills. I replied “What if it was 8%? Would that be enough?”
He indicated that in that case it would probably be enough. But he (rightfully) asked “Isn’t investing in high-yielding stocks riskier?”
I explained that I wasn’t talking about high-yielding stocks. Instead, I was talking about blue chip companies with yields in the 3%-4% range. I explained that he could boost his effective annual yield to ~8% by selling covered calls on his positions. To which he responded “Oh, I would never trade options. They are too risky.”
Allow me to disabuse you of this notion. My colleague Jim Fink is fond of saying that 70% of people who buy options lose money. I have heard similar statistics over the course of my life. Thus, it makes more sense to be on the selling side of that transaction.
Trading options can be risky, so don’t trade them. Just sell them and pocket the premium. Use them to lower risks and boost returns.
However, although selling covered call options isn’t risky in the conventional sense, there can be consequences. You need to be certain you are comfortable with those consequences if you decide to use this strategy.
Let’s first review some terminology. An option gives the right, but not the obligation, to buy or sell shares at a defined price and on or before a defined time. You can buy or sell options.
A person who buys a call option is buying the right to purchase 100 shares of stock. The person who sells a call is creating the obligation to potentially sell them.
Options define the price at which the trade would be executed (the strike price), the date by which the trade would occur (the expiration date), and the premium (the cost) of that option.
The share price of the stock is important since you have to have 100 share increments of any company for which you plan to use this strategy. If the share price is $4.00, an option contract represents $400 of stock. If the share price is $300, it represents $30,000 of stock. For example, if you want to sell a call on NextEra Energy (NYSE: NEE), which closed last week at $305.60, you need to own $30,560 of NextEra stock.
The Three Caveats of Selling Covered Calls
I want to highlight several caveats that you should understand if you plan to use this strategy.
First, do not use this strategy with positions that you are unwilling to sell. Sooner or later the positions will be called away from you, albeit at a nice profit if you execute it correctly. However, if shares do start to rise and you begin to have second thoughts, below I add some pointers on what you can do.
The second caveat is not to use this strategy for positions you want to exit quickly. If you feel that shares are likely to decline and you want to sell, don’t sell a call that will keep you in that position while the call is active.
Likewise, if you are sitting on a big gain and want to lock that in quickly, just sell the position. This strategy is for positions that you are happy to keep in your portfolio, but willing to sell at the right (future) price.
The third caveat is not to use this strategy if you don’t want to lock in a loss. For example, if you bought shares of a company for $100, and they are now trading at $70, don’t sell a call with an $85 strike price unless you are willing to potentially lock in that loss.
For companies that are in the red in my portfolio, I usually wait until they have recovered somewhat before using this strategy. In this example, I would probably wait until I could get a decent premium on a $105 call before executing the strategy.
Finally, note that this strategy will not work with all your holdings. For some, you simply won’t find a high enough option premium to justify the risk of your shares being called away.
How To Boost Your Yield To 8%
Let’s consider one example. General Mills (NYSE: GIS) is a $38 billion consumer staples company that owns iconic food brands such as Cheerios, Haagen-Dazs, Betty Crocker, and Pillsbury. The company presently pays a quarterly dividend of $0.51/share, for a annualized yield of 3.3% at last Friday’s close of $62.37.
If I look at the option chain for the company, I see an option that expires on 04/16/2021 with a strike price of $67.50 and a most recently traded price of $2.00. That premium gives nearly the annual dividend in just under six months. Annualized, the yield premium is 6.5%, which pushes the total annualized yield on your GIS shares to 9.6% (since you can sell another covered call in six months).
If your shares get called away in six months (i.e., GIS shares are trading above $67.50 at expiration), your total return (including the call and two dividends) is 13.8% for a holding period of six months.
Of course you can bump up the strike price to $70 or $72.50 if you require a higher premium, but you will in turn receive a smaller call premium. It really just depends on whether your priority is certain income-generation or potential capital appreciation.
What happens at expiration if the share price is below the strike price? The option contract is now void, so you can repeat the process. Sell another call against your position. Most of the time this is exactly what happens, which is why this is a conservative way to boost the income from your positions.
Note that this strategy does not protect you against steep market declines. If the share price fell from $100 to $90, your paper loss is still $10. Except in this case it’s a bit less because of the premium you collected for selling the option. The strategy does provide some offset to losses, but won’t prevent you from experiencing them.
Editor’s Note: Robert Rapier has imparted powerful trading tools, but the above article only scratches the surface of the expertise on the Investing Daily team.
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