Why You Should be Selling Covered Calls
Many people believe that options are risky and that they're a great way to lose all of your money. This can be true, but only if you sell them naked. That means that if you sell a put, you don't have the money on hand to buy the stock at the price you contacted to. If you sell a call, it means you don't have the stock on hand to sell if the call is executed.
Those are not strategies anyone but the most sophisticated and well capitalized investor should use. In fact, many retail brokerages do not allow these techniques to be used.
But there is a low risk options strategy that every investor should think about using. It's the covered call strategy.
This is a strategy you use when you are mildly bullish on a stock. What it involves is owning 100 shares of each stock for every call you want to sell. Then you sell a call option with a strike price above that of where the stock is trading right now. Each investor will set his or her own criteria for where they want to set the strike price.
For example, today, which is the first trading day after September's options expired, we sold GE $17 calls with an October expiration date. We got $25 before commissions for each call we sold. The price we purchased the GE stock was $15.98, so that means we earned a return of 1.2 percent after commissions.
Now, you never get money for nothing unless you're the band playing in Dire Strait's Money for Nothing. And then you get your chicks for free, too. Unfortunately, that's now how things work for us.
So what you give up in exchange for this money is any gains that you would book if the stock goes over the strike price.
In this case, if GE's stock price goes above $17, we don't benefit. We sell the stock at $17, even if it goes to $100. When this happens, traders say your stock was called away.
It's often been said that nobody went broke taking a profit. Well, that's what we're willing to do here. We'll take the money now and if our profits are limited to $1 a share, we'll accept that. If that happens, our capital gains on the trade will be 6.3 percent and the options trade will add another 1.2 percent. That's a 7.5 percent gain in a month, or an annualized return of 90 percent. Anyone want to turn that down?
And if our option expires worthless, as two thirds of them do, we keep the money and the shares.
It can be very beneficial for investors to do this. Today, on a portfolio worth around $70,000, we sold around $700 in calls. That's a one percent return and that money is in our account right now. Over a twelve month period, if we do this consistently, we will earn $8,400 in options income. That's on top of any capital gains we see.
Now, this strategy is used when you are mildly bullish. If you're bearish, then you sell your stock. But for us, since we've got core holdings that we want to keep for a very long time, using this strategy is a great way to boost our returns.
It's one all investors should consider.
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