Investors are anxiously seeking novel ways to ramp up their portfolio income in today’s ultra low rate environment.
The most popular way to ramp up your income by using options is writing covered calls.
Covered call writing means selling calls protected by stock held in your portfolio. This is why the sold calls are referred to as covered since you already own the shares.
How Does It Work?
Remember how options work. Purchasing one call option gives the buyer the right to buy one hundred shares of stock at a certain price called the strike price during a certain time frame.
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If you are going to sell the call rather than buy it just think the opposite. You are selling the right to the call purchaser to buy one hundred shares of stock from you at the strike price.
If you do not own the stock, selling a call for income is called selling naked. Hence the difference between covered and naked in option terminology.
Most of the time, we are talking monthly time frames when it comes to options. However, weekly options exist and can be a lucrative source of income for covered call sellers.
Where Does The Income Come From?
The capital that you earn from selling a covered call is the amount of money that the buyer pays you for the call. This money is called the option’s premium.
An easy way to visualize this is to think that the call option you sold was $3.00. Being that each option signifies one hundred shares of stock, $300.00 minus commissions and fees will be transferred to your account. Know think about holding 1000 shares of stock and selling 10, $3.00 options. This equals $3000.00, minus fees and costs, of course, instantly transferred to your account.
Hopefully you can now see how this easy to use strategy can ramp up your returns.
What Can Go Wrong?
Whenever you sell a covered call you are promising someone that they can buy your shares at the strike price of the call at any time during the life of the option. When the buyer decides to buy your shares it is called exercising the option.
What can happen is the price of your stock can move above the strike price of the option that you sold. When this happens, it is almost a certainty that the buyer will exercise the option and take your shares.
Remember, the option buyer still has to pay you for the shares. The buyer simply can’t take your shares without payment.
However, this can reduce your upside with the stock significantly. This is why the writing calls for income works best on stocks that are not moving or moving extremely slowly upward.
Stated simply, a covered call can offset downside risk due to the premium received or add to upside gains. A good way to think about it is that you are earning income today in exchange for selling the potential of greater future gains to someone else.
Here’s A Basic Example without taking commissions into account
- You own 100 shares of XYZ at $50 per share
- You investing premise is that XYZ will stay below $55 per share over the next month.
- You sell 1 call option with the strike price of $55 for $500.
- The premium is instantly deposited into your account. You are now obligated to sell your shares at $55 during the life of the option should the option be exercised.
Now several things can happen
- Shares move higher than the $55.00 strike price
If ABC shares move above $55 on or before the expiration day of the option ( the 3rd Friday of every month) the purchaser of your option will likely exercise it, automatically buying the shares from you at $55 per share. This means that $5500 will be deposited into your account from the sale of the one hundred shares. You now have $5500 plus the $500 option premium equaling $4000 to reinvest or spend.
- The Shares do not move or remain below the strike price
If ABC stays at or below $55 by the expiration date, then the call option expires worthless to the buyer. This means you get to keep the entire premium paid, minus commissions, of course. Now you can go ahead and do the same thing at the same or different strike price for the next month.
Many investors use this method on a consistent basis to drastically ramp up their income!
Now the next method to increase your portfolio’s monthly income is a little more esoteric but not by much! This method is the earning of income by selling or writing of puts.
Put selling can be used for two different but related goals. First and foremost, put selling can be used to create an income stream by collecting the premiums earned for selling the put. Many investors do this on a steady basis to ramp up returns.
Secondly, and less well known, is puts can be sold with the goal of purchasing the shares at a lower price in the future. This tactic can earn income plus have the added bonus of owning a stock that you wish to own at a discounted price.
Just like with calls, each put signifies 100 shares of stock. Every put that you sell creates the potential that you may be forced to purchase the shares at the strike price.
I know it may seem difficult to understand at first but selling cash secured puts has the exact same risk profile as covered calls. Using puts for income does not require you to own the shares first, but may result in your ownership in the future.
Let’s take a close look at an example from the Chicago Board of Option Exchange website.
After thorough research an investor decides he’d like to invest in ZYX stock. It’s currently priced at around $48 per share, but he feels it would be a good buy at around $45 (or lower) and that the stock could reach that level within the next two months. The investor can always place a limit order with his broker to buy ZYX shares at $45, but he decides to write a ZYX put in order to acquire the same shares if he’s assigned. In the marketplace there are two 2-month ZYX puts available that might suit his purpose: an out-of-the-money ZYX 45 put trading for a quoted price of $1.50, and an in-the-money ZYX 50 put trading for $4.00. Selling either of these puts would result in a purchase of ZYX stock below the current market price of $48 per share if assignment is made, but at different net prices. The investor should sell one put contract for every 100 shares of stock he’s willing to purchase.
Remember, by selling the put with a $45 strike the investor takes on the obligation to buy 100 ZYX at $45 per share should he be assigned at any time before the option contract expires, and at a net purchase price of the $45 strike less the put premium received. By selling the $50 put the investor would be obligated, if assigned, to buy 100 ZYX shares at a net price of the $50 strike less the put premium. In either case, the obligation is there to buy stock at these prices no matter how low ZYX might decline in price by expiration.