These days, everyone is looking for ways to squeeze more profits from their portfolio of investments.
This is particularly true during times of low volatility when stocks just seem to sit there for extended periods. One proven tactic for boosting income from stocks you already own is called covered-call writing. Writing (also known as selling) call options against one or more stocks in your portfolio can generate a consistent income stream in a low-risk manner. Combine this income stream with a well-designed dividend reinvestment strategy and it could supercharge your portfolio.
Covered-call writing means you sell call options against shares of stock you already own. One call option provides the buyer the right to buy 100 shares of the stock for a particular price during a predetermined time frame. By selling the call option, you are selling the buyer rights to purchase 100 shares of stock from you at an agreed price, otherwise known as the strike price.
Traditionally, options expire on the third Friday of the month, but weekly options are also available. Since each option contract controls 100 shares, covered-call writers should sell one call option per 100 shares owned. The selling of the call option is considered "covered" since you already own the shares you might be obligated to sell. This greatly reduces your risk as opposed to "naked" call writing, which means selling calls without owning the stock first. When you sell a call option, you receive the amount the buyer paid for it. This is called the premium and it's income you get to keep.
Let's pretend the call option you sold was $3. Because an option represents 100 shares of a stock, you will instantly receive $300 before broker commissions.
I know it seems too good to be true. So what's the catch?
Well, the catch is that by selling the call, you are obligating yourself to sell your 100 shares at the strike price of the call. This mean the buyer can purchase your 100 shares at any time during the life of the call option at the strike price. If the buyer decides to purchase your shares at the agreed-upon price, then this is called exercising the option. If the price of the stock rises above the strike price of the option, then it is likely you will be forced to sell your shares to the option buyer. As you can see, this can limit your upside gains dramatically.
However, with a very slow climbing, neutral or falling stock, covered calls can enhance your return during the same period. In other words, a covered call can offset downside risk due to the premium received or add to upside gains. But you are accepting the cash today in exchange for any gains above the strike price of the call option.
Here's a basic example
You own 100 shares of Microsoft (Nasdaq: MSFT) at $27 each.
Your investing premise is that Microsoft will stay below $28 during the next month.
You sell one call option with the strike price of $28 for $100. The premium is immediately deposited into your account. You are now obligated to sell your shares at $28 during the life of the option should the option be exercised.
Now several things can happen
1. The stock moves higher than the strike price
If Microsoft shares move above $28 on or before the expiration day of the option, then the purchaser of your option will likely exercise it and buy the shares from you at $28 per share. This means that $2,800 will be deposited into your account from the sale of the 100 shares. You now have $2,800, plus the $100 option premium equaling $2,900 to reinvest or spend.
2. The stock stays at or below the strike price
If Microsoft stays at or below $28 by the expiration date, then the call option expires worthless to the buyer. This means you get to keep the entire premium paid before broker commissions. Now you can go ahead and do the same thing at the same or different strike price for the next month, if you wish. There are multiple permutations on the same covered call concept. One of the most popular is called the buy/write strategy. This is the simultaneous buying of the stock and selling the call options. The buy/write strategy is so popular, there are ETFs, such as PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP) dedicated to its use.
Risks to Consider: There is no free lunch in the stock market. Although writing covered calls is considered a relatively safe strategy, there is still risk. If you are really bullish or bearish, then it's not the best strategy to use. In addition, do not write covered calls if you are not willing to sell the shares at the strike price. I strongly suggest reviewing options and their inherent risks at the Option Industry Council's website if you have questions at all.
Action to Take –> Covered calls are a time-proven strategy for generating additional income in your portfolio. They are used most wisely if you are expecting a steady or slightly rising stock price. When combined with a dividend reinvestment strategy, covered-call writing is a great way to supercharge any portfolio.
– Dave Goodboy
This article originally appeared on StreetAuthority
Author: Dave Goodboy
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