by Jeff Reeves | May 10, 2013 9:53 am
I took a lot of guff for a column last week horseracing Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL). I won’t list the myriad dissenting arguments here — many of which were valid — but I do want to address one idea that kept popping up: that Apple was instantly superior because of its income potential.
I will not dispute the power of a plan to return $100 billion in capital back to shareholders via dividends and buybacks. But if you think this is the only way a tech mega-cap can provide you with income, think again.
Because for savvy investors, Google can pay you regularly too — to the tune of over 4% annually income, paid via the premiums you received by selling covered calls.
Covered calls are a powerful way to deliver extra returns out of stocks you don’t mind owning for a while, and if you’re willing to trade the potential for a breakout for the certainty of a regular income stream.
Here’s how it works:
Let’s say you run out and buy 100 shares of GOOG today at roughly $870. You then turn around and sell a contract for July 20 calls with a strike price of around $960 for those shares, netting about $10 a pop.
If Google hits $960? Well, you “only” make 10% plus your $10 fee — an additional 1.1% “dividend,” based on your $870 share price. And there are worse things in life than to lock in a double-digit gain.
If Google moves sideways or drifts a little lower? That $10 contract fee is yours regardless of whether the options get exercised or not — so the 1.1% payday is still yours.
The risk, of course, is that you are capping your upside. If Google soars to $2,000, that’s fantastic for the gal who purchased your calls — but sucks for you, since you’re forced to sell at $960 now. Inherently you only get to keep underperformers by selling covered calls, and your best picks are forced out of your portfolio.
It’s also worth noting that if Google crashes and burns so much that the meager income from selling a covered call doesn’t offset your losses, both you and the call-buyer will be cursing Larry Page and your bonehead investment strategy.
But if you have a stock that you think isn’t likely to break out but will bounce back even if it hits a rough patch, covered calls are a great strategy.
Especially if your options contract goes unexercised for a while … because that allows you to repeatedly sell calls and keep generating income. After all, if Google moves sideways for a year you may be able to sell covered calls every three months for $10 a pop — netting $40 for a 4.6% return on your investment.
Or better yet, do the same thing with Apple, which pays an ordinary dividend that also generates income. As long as you aren’t forced to sell your shares you are still eligible for the regular quarterly paydays.
Sell some covered calls on top of that 2.6% dividend, and it’s not unrealistic to squeeze double-digit profits out of Apple even if it goes nowhere for a year.
If you’re looking to employ this covered-call strategy, there are a few things to keep in mind. Pick stocks that are stable enough to be worth holding for a while — since the biggest premiums are often on contracts that are at least two months down the road — but also look for stocks that don’t seem to have a lot of breakout potential left and won’t disappoint you in the event you’re forced to sell a bit early. My general rule is to try and generate 1% in income while guaranteeing no less than 10% gains should your call contract be exercised.
Keep in mind that options contracts are very dynamic. Check the latest options chains for current pricing.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.
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