Covered calls can be a great way to generate income. For those who are interested in getting a bit speculative about a market top, now might be a good time to sell covered calls — but I would do it against certain blue-chip stocks.
Right now, the market is 20% overvalued, and stocks like Apple Inc. (NASDAQ:AAPL), The Walt Disney Co (NYSE:DIS) and Southwest Airlines Co (NYSE:LUV) are big names that feel stretched as far as valuation is concerned.
They have brands that dominate their sectors — I mean, think about the global brands that go along with Apple, Disney and Southwest — and because of that, they carry an extra margin of safety. Even more than the market itself has. So when that big correction comes (it will), they should bounce back pretty quickly.
Until then, it might be worth using covered calls to squeeze some extra upside out of these stocks, which I don’t believe have much more upside for the time being.
Here’s a look at three income-generating plays.
Covered Calls on Apple (AAPL)
If you missed the big news, Apple Inc. (NASDAQ:AAPL) roared back to life after its most recent earnings report. Everyone was in the doldrums about Apple’s potential, but one good report, and the stock rose 40%!
I still think the market’s position on AAPL stock makes it a fine choice to sell covered calls against. I believe Apple will be confined to a trading range for a bit, although one might argue that another great quarter could send it even higher. So if you already hold AAPL, maybe just sell covered calls against half of it.
I prefer stocks that have enough volatility to offer a nice premium, and even better if it is stuck in a trading range. Thus, I can even buy the stock and sell covered calls against it, and even repeat that move even if the stock gets called away.
As I write, AAPL stock is at $141.80. You can sell the 26 May $142 covered calls for $3.72 here. If shares trade at or above $142 at expiration, shares will be called away. But if AAPL trades below, the contract will expire worthless and you keep both the shares and the premium.
The $3-plus here exceeds my 2% desired target for covered calls. In fact, at 2.5% for just a 25-day holding period, it’s a 36% annualized return.
Covered Calls on Southwest Airlines (LUV)
Southwest Airlines Co (NYSE:LUV) has been a great options trading vehicle for quite some time. Like most airline stocks, it has significant volatility and is often lodged in a trading range. Owning LUV stock here at $55.50 is fine, but it really feels toppy and I think selling covered calls is a good move.
You have a couple of choices, depending on sentiment.
There’s a near-term play, in which you sell the 26 May $55.50 covered calls for $2.50. This is a whopper of a play, yielding a very generous 4.5% in just 47 days, or about 32% annualized.
Another shot is to look much further out, if you think both the stock and market are toppy, and consider selling the 15 Sept $55 covered calls for $4.55. Now, you will lose 50 cents in capital losses if called away, but that still would provide you with a 7.1%. If not, you’re looking at an 8.1% return.
Covered Calls on Disney (DIS)
Walt Disney Co (NYSE:DIS) may be a blue-chip stock, but man, the whole ESPN thing is really getting me down.
Somehow, DIS stock remains at a 52-week high despite some very real and troubling problems at ESPN. I have to say, I would’ve thought Bob Iger would have figured something out by now, but Disney is being propped up by Beauty and the Beast and its $1 billion box office, and the onslaught of Star Wars films, each and every year, along with Marvel’s output.
DIS stock trades at $113. Once again, consider two moves here:
The first is to think about selling the 26 May $113 covered calls for $2.75. That’s a 2.6% return, which is generous for Disney.
Or you could sell the 15 Sept $115 covered calls for $3.95. If called away, add in another $2 in capital gains, for a total return of 5.3%.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He has 20 years’ experience in the stock market, and has written more than 1,600 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com. As of this writing, he owns DIS.
