Stock investors in search of income often gravitate towards high dividend paying stocks. The likes of AT&T Inc. (NYSE:T), The Coca-Cola Co (NYSE:KO), Procter & Gamble Co (NYSE:PG) and Altria Group (NYSE:MO) are well known among income seekers as their dividend yields are among the highest available in the world of blue chips.
And yet, as good as a 3% to 5% yield is in a world of record low interest rates, it sure would be nice to squeeze a little more money out of these dividend darlings. Or, better yet, how about turning your favorite growth stock into an income generator?
Such sweet-sounding objectives become achievable once you master the art of covered call writing.
Often touted as a gateway strategy, covered calls are one of the first trades greeting equity owners venturing into the world of stock options.
As a stock investor, you’ve already familiarized yourself with the first half of a covered call — buying stock. The second half entails getting paid for a promise. Specifically, a promise to sell your shares at a price of your choosing. In exchange for bringing on this obligation, you are compensated by receiving some cold, hard cash. And the best part of the strategy? You can re-up the promise to sell your stock every single month, varying the agreed-upon price at will.
So how exactly do you make this promise? Simply by selling a call option against your stock. Specifically, sell one call option contract for every 100 shares of stock you own. That’s because each call contract obligates you to sell 100 shares.
Aside from the obvious benefit of scoring some income each month from the sale of these covered calls, you also acquire a bit of downside protection to buffer minor losses in the stock.
For instance, if I sell a covered call for $5, I can withstand up to a $5 drawdown in the stock before I actually lose money on the total position at expiration. In trader jargon, the premium received from selling monthly covered calls lowers your cost basis, which has the wonderful effect of improving your risk-adjusted returns over time.
Here’s a look at an example using a trade from late last year.
Covered Call Writing Example
Let’s say you just bought 100 shares of Coca-Cola looking to capture its 3% dividend yield, but you want to juice your returns. If KO traded at $42.79, you could sell the a two-month $43 call for 65 cents. By selling the call, you obligate yourself to sell 100 shares of KO at $43 up until expiration, which is 50 days away for this example. (Remember: Options prices are listed per share, so when I say you sell the call for 65 cents, that means you are receiving $65.)
Most traders look to sell short-term call options, say one to two months, to exploit the higher rate of time decay that hounds options approaching expiration. It also affords more flexibility since you can adjust the agreed-upon sale price as your outlook on the underlying stock changes. When more bullish, you may consider selling a covered call a few strikes out-of-the-money. When neutral, you could sell an at-the-money call.
Now, let’s consider the potential income available in the position.
If KO stock remains below $43, the two-month $43 call will expire worthless allowing you to pocket the $65. By capturing $65 of income on a $4,279 investment (the cost of KO stock), you effectively generated a 1.5% return.
While it doesn’t sound like much, let’s not be too hasty in passing judgement. That’s a 1.5% return for a mere 50 days. Following this month’s expiration, you can sell calls for each month thereafter. If you duplicated your 1.5% return every 50 days, you’re looking at an annual return of just under 11%. And that’s not even counting the 3% dividend that KO paid you along the way.
All told, you’re looking at a potential 14% return if the stock cooperates. Sounds a great deal more attractive than the 3% dividend, no?
So what are you waiting for? Embrace covered call writing and become a bona fide cash flow king!
