Retirement and income investors might not think that options are for them, but they are. Selling covered calls is a simple strategy that is consistent with the goal of producing income. It also involves blue chips, so that too makes it consistent with a conservative approach to investing.
Selling covered calls is a strategy in which you hold a certain stock, then sell the right for someone else to buy that stock from you at a given price (strike price), on or before a certain day (expiration date).
The idea is that you think the stock isn’t going to go meaningfully above the strike price by the expiration date. If the stock doesn’t breach that strike price by a lot before expiration, or doesn’t close above it on expiration, you’ll keep the money that you were paid, as well as your stock. If the stock closes above that price, however, you will be forced to sell the stock at that price.
We’ll take a look at three trades on some popular blue chips to get you started.
Covered Calls on Boeing Co (BA)
Boeing Co (NYSE:BA) is one of these blue chips — one that also reported great earnings recently. It trades at $148 as I write. You could sell the Mar $150 covered calls for $2.15 per contract. With this trade, you collect $215 less commission, or a 1.5% return for an expiration date that is 37 days out. That represents an annualized return of 15%.
If Boeing closes above $150, then you not only keep your $215 premium for selling the call, but you’ll also get the $2 in capital gains because you are selling the stock at $150. If not, then you at least keep the $215 premium.
What if Boeing soars way past $150? It could, in which case you have “missed out” on that extra appreciation. Still, nothing is stopping you from either buying back the call you sold (which may or may not come at a loss) or simply buying more Boeing stock to replace the shares that are going to get called away.
Covered Calls on Automatic Data Processing (ADP)
Automatic Data Processing (NASDAQ:ADP) is another of these blue chips that work well with covered calls. It trades at $86.50 as I write. You could sell the Mar $87.50 covered calls for $1 per contract. With this trade, you collect $100 less commission, or a 1.15% return for an expiration date that is 37 days out. That represents an annualized return of 11.3%.
If ADP closes just above $87.50, then you not only keep your $125 premium for selling the call, but you’ll also get the $1 in capital gains because you are selling the stock at $87.50.
If ADP closes below $87.50, you’re theoretically “stuck” with the stock — but there are a lot worse fates than being stuck with a rock-solid blue chip like ADP. (Besides, if you’re already holding ADP anyway, why would you be that upset?)
Covered Calls on 3M Co (MMM)
3M Co (NYSE:MMM) is one of my favorite blue chips for covered calls. It presently trades at $165.82. I like the Mar 20 $165 covered calls for $3.45 per contract. With this trade, you collect $345 less commission, though if called away, you suffer $82 in capital losses. All told, that’s a 1.59% return for an expiration date that is 37 days out. That represents an annualized return of 15.9%.
If MMM closes above $165, then you keep your $345 premium for selling the call, but as mentioned, you’ll lose $82 because you sold the stock at $165 instead of the $165.82 you could have sold it for at the time. If the stock falls below $165, then congratulations, you keep the premium and the stock.
One note of caution on taxes. If you have a stock that has significant gains since you purchased it, you may not want to use covered calls. If called away, it would trigger a capital gains tax. It is best suited for new positions, or positions where you have a loss or mild gain.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He is the manager of the forthcoming Liberty Portfolio, has 20 years’ worth of experience in the stock market and has written more than 1,200 articles on investing. As of this writing, he did not hold a position in any of the aforementioned securities. He can be reached at TheLibertyPortfolio@gmail.com.
