Covered Calls
The goal of using this strategy is to achieve a consistent 4% or more per month. This is a get rich slowly method generating consistent monthly income. This is considered a conservative strategy and it is authorized to be used in an IRA.
It involves buying 100 shares of stock and giving someone the right to buy it from you in 30 - 45 days. This right is an option that you would receive a premium for. You must buy in 100 round lots, because an option contract is for 100 shares.
An example of this:
02/14/17 Stock XYZ 19.50
MAR 17 2017 23.00 C Bid 0.50
XYZ is currently at 19.50 and you sell a call option at a strike price of 20.00 due in 31 days.
By selling the call you are giving someone the right to buy the stock from you at 20.00 a share on or before 03/17. For his right you would receive .50 a share as a premium. The strike price is the price you are willing to sell your stock at.
You would receive $50 as a capital gain when the stock is sold at 20.00 a share.
Buy 100 shares at 19.50 = $1,950.00
Sell 100 shares at 20.00 = $2,000.00
Net gain $50.00
You would receive $50 for selling the option for the premium (yield)
.50 x 100 shares = $50.00
The total profit is $100 or 5% for 31 days. These profits can then be rolled into another covered call next month to compound the earnings.
That is what happens XYZ closes at 20.00. When the closing price is at the strike price that is called At the Money. You will be called out of your stock.
What happens if the stock goes through the roof and closes at say 50.00? You will only receive still the 20.00 for your stock, because you sold the right to the market to buy it from you at the strike price.
What happens if the stock closes below that price at around 18.00? The option contract you sold would expire worthless and you still own the stock at 18.00. You can then sell another call for the next month for another $50.
Do not sell the call if the company is posting earnings in that time frame. You can still own the company. Just don't sell the option that month.
There is risk in this strategy and it is in owning the stock. So, select a company that you would want to own at this price anyway.
When entering into a position you will need to have defined your exit on both the upside and the downside. The upside and neutral outcomes are known up front during the initial setup. For the downside, what is the maximum you are willing to loose on this position?
There are a couple of strategies with losses:
1. Close out the position when it reaches your limit
2. Continue to own the stock and manage the position to maximize cash flow. You still own the stock and can sell another option for the next month. This way you would generate cash flow off the stock. You can turn a negative position into a positive or at least mitigate the losses.
The 3-4% per month is considered conservative and a more aggressive approach will go for 5-8% returns. The stocks that have high fat premiums are volatile with deeper price swings in both directions. Remember, you would want to own the stock at this price anyway.
You own the stock and are in control. You can always buy the option you sold back and is the first step in managing the position.
There is a strategy to just capture the premium, You increase the time frame on the option. If you are willing to own the company over the next 90 days, you could capture a +5% premium just for cash flow. If the price of the stock fluctuates down the price of the option will drop. If the price of the option drops to 1% you can buy back that option to lock in a 4% yield. Then you would wait util the price of that option bounces back and sell it again.
The Blue Collar Investor Blog by Allen Ellmen is a great resource for this technique.
After trying this strategy for a year I found it difficult to manage effectively. I had selected a few stocks that did well, but my gains were capped. I had a few losses, that effectively wiped out much of the profit I had. The most successful use of this strategy was went I had picked a stock, had a 20% gain, and then sold the call against it