I have been doing some reading recently on the concept of Covered Calls as a way to generate income from your portfolio. To describe what this is, I cannot do any better than Investopedia.com has:
An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.
This is also known as a “buy-write”.
For example, let’s say that you own shares of the TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ for $26.00, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:
a) TSJ shares trade flat (below the $26 strike price) – the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.
b) TSJ shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.
c) TSJ shares rise above $26 – the option is exercised, and your upside is capped at $26, plus the option premium. In this case, if the stock price goes higher than $26, plus the premium, your buy-write strategy has underperformed the TSJ shares.
Of many of the various options strategies that exists (and there are many) this one is regarded as the one with the lowest risk. The premium that the seller of the option receives is extra income that you would not normally have realized by just sitting on the stock. If the stock stays below the strike price then you get to keep the premium and hold on to the stock. If it rises above the strike price, then your risk is having the stock bought from you at the strike price.
If I were to do this, I would buy slightly out of the money options that gave me a good return through the premium. However, I would need to be very comfortable with the fact that my shares may be called away from me. If the stock rises a lot, I will miss out on that gain. I may try to do this and see how it goes (with money I can afford to lose – if that exists). I will let you know how it goes.
The buy-write strategy is actually safer than a straight long of the stock if one is loss-adverse; you sacrifice a possible huge gain of the underlying in exchange for less painful loss in the event of a downturn. Whether it’s worth it depends on how much premium one can collect for the call.
Watch out for the effect of capital gains taxes when options get exercised.
I’ve been doing this for years and I’ve been blogging about it for a few months now. The major risk, in my opinion, is if there is a major downturn in a stock and you can’t quickly liquidate your position because of the options exposure. If you’re a long term investor then this particular bit of risk is of little consequence.
By the way….you’ve hit on my favorite “trifecta” for stocks.
1. Earning money via dividends.
2. Earning money via covered calls.
3. Earning money via stock appreciation.
I have recently started writing covered calls in a small IRA and blogging about it. I am finding that figuring in time preimum, spreads and commissions make it a challenge to find trades with acceptable returns. I do love the challenge and I am having a lot of fun with it.