Increase your Stock's Income by Selling Covered Calls
Many people are familiar with the simple buy and hold strategy with stock investing. Have you ever considered low risk ways to increase your return? There are tons of very good company stocks out there that offer a healthy dividend but, you can increase your yield many times over with a simple strategy of selling covered calls.
What is covered call writing?
As the concept of selling covered calls may be new to you I will cover some of the basics. A call is a type of option on a stock. When you write calls (sell them) you are offering a contract to buy your stock for a certain price on or before a certain date. Now in exchange for this option you will be paid a fee this is referred to as a premium.
Ideally you want the call option you sell to expire worthless so you can turn around and, sell another call option. For example: You own 100 shares of a company we will call “XYZ”. It is currently trading at $50 you sell a call option to buy XYZ from you at $52 per share. In this example let’s say you are receiving a premium (payment) of $1.00 per share or $100 per 100 shares. If your stock stays flat at $50 or never passes $52 the option you sold will expire and you keep the premium. In the event the stock goes down you keep the premium. Finally if it goes up to say $53 and the option is exercised you have to sell the stock at $52 but, you still have realized a $2 gain on your stock AND you still keep the $1.00 premium.
In this example you maintain control over the stock the entire time so you get all your regular dividend payments. The reason this is referred to as covered call writing is because you have the stock to “cover” the call you are writing. There are people who write “naked calls” that is they do not own the stock they write options on. This is an advanced strategy and, offers A LOT of risk not to be recommended for inexperienced traders.
Selecting the right stock for selling covered calls
The premiums paid on a stock option will vary widely from stock to stock. Factors that can affect option premium are:
- Volatility: How much does the underlying stock move. Higher volatility means higher premium but, also more chance the stock will be called away.
- Time value: This is the length of time until the option contract expires.
- Intrinsic Value: This is the actual value of an option if exercised immediately. For example if your stock is at $50 and you sell a call to buy the stock at $48 it would have $2 of intrinsic value.
Make sure when selecting stock for selling covered calls to evaluate the stock itself and NOT the value of the options. Some option premiums may be very attractive; there is a reason for this. In all likelihood large price swings in the underlying stock are the reason. Never choose a stock based solely on the options premium you will collect. Always pick sound fundamentals for any stock you hold and, write covered calls on.
Paper trade before you begin
Before implementing a strategy to start selling covered calls you need to decide if it fits your investment objectives. Your next step is to paper trade, select an option for your particular stock and track it over a period of time and see how it performs. Once you are satisfied that you can write calls at a certain price without your stock being called away you are good to go. Assuming your stock is fairly stable in price you can realize an extra income stream. Always sell options with a decent amount of time value (3 to 6 months) and, that are out of the money (above your current stock price).
So there you have it, a straight forward way to begin selling covered calls and, drastically improve the yield on stock you already own!