There is an options trading strategy that offers a powerful, yet often overlooked, opportunity for generating consistent monthly income. An increasing numbers of investors use this strategy – and thousands of our clients have used it for years – to generate more income, and experience less volatility in their portfolio.
This option trading strategy is selling covered calls
Learning how to sell covered calls to generate portfolio income may be a game-changer for you. Even better, it can be a big key to more income in retirement, which is exactly when you need it the most.
Selling covered calls is critical to building wealth
While most people define wealth simply by looking at the sum total of their stock investment portfolio, the more meaningful number is the withdrawal rate you’re able to take to pay your bills in retirement.
In other words, if you were able to generate a monthly paycheck from your portfolio for thirty years in retirement and still have a nest egg to pass on to your children, wouldn’t you consider that to be real wealth?
For investors who are in, or nearing, retirement, the number one job of their portfolio must be to produce a paycheck.
Our strategy, the Snider Investment Method, has two critical goals it strives to achieve through the use of stock investing, options trading, and cash management techniques.
- Goal #1 – Generate 1% yield from your stock portfolio, on average. If you’re still working and don’t need the income, simply reinvest it to benefit from compounding growth.
- Goal #2 – Avoid any permanent loss of capital through our strict, proven set of rules that help you control emotional reactions to market changes and a powerful stock selection process.
Usual suspects: traditional income investment options
Traditional sources of investment income include: bonds, CDs, dividends, money market funds, Treasuries, real estate and insurance products – like annuities. But unfortunately, none of these investments pay very much.
There is a good chance none of the aforementioned investment vehicles will enable you to survive through what could very well be a long retirement, which is why you need a better plan for income replacement.
What is a call option?
A call is an option contract that gives its owner the right, but not the obligation, to buy a stock at a specified price, called the strike price, on, or before, a specified date. This date is called the expiration date.
When you buy a call, you have the right to buy a stock. People who buy calls are considered bullish. They’re betting that the price of the underlying stock will increase substantially before expiration.
For every call that is traded, there’s both a buyer and a seller. When you sell a call, you have the obligation to sell shares. The primary benefit of selling is that instead of spending money – you earn it!
Types of calls
There are two types of calls. First there are naked calls. When you sell a naked call you have the obligation to sell shares of a stock that you do not own. Selling naked calls is a risky and highly speculative strategy.
The second type of call is a covered call. Unlike a naked call, with a covered call – you own the underlying stock. Covered calls are considered to be one of the most conservative and effective ways to trade options.
The rising popularity of covered calls
Since their introduction in 1973, standardized equity options have become increasingly popular. Approximately 50 million puts and calls are traded every day. Since each option contract represents 100 shares, those options control the equivalent of about 5 billion shares each day. And of these options trades, the most commonly used is the covered call.
Selling covered calls to generate a paycheck
You sell a call against the shares you already own. When you sell that call, two things happen.
- First, you are obligated to sell your shares at the strike price on, or before, the expiration.
- Second, you receive option premium, which is the amount you’re paid to sell the call. You get to keep that premium regardless of the expiration outcome (whether the call buyer exercises their right to buy your shares or not).
The great thing about this option trading strategy is that you can apply it to stocks you already own.
Benefits and risks of selling covered calls
The benefits of selling covered calls are pretty straightforward.
- You can generate a monthly paycheck when you sell calls on a routine, monthly basis.
- You may increase the yield on your investment by adding in the option income you earn to your portfolio.
- You will likely experience less market volatility. Option premiums can offset some or all the price declines when your stocks drop in price.
Callan Associates evaluated an index that used Covered Calls with the S&P 500 for an 18 year period and found that the index that used Covered Calls not only outperformed the S&P over the 18-yr period but it also experienced less volatility.
In another study, two PhDs, Keith Black and Edward Szado analyzed 119 mutual funds, some of which have been using options since 1988. They found that these funds experienced higher returns with lower volatility swings than the S&P 500.
Now let’s look at the risks.
The biggest risk is stock ownership. If a stock you own drops in price, then you could lose a considerable amount. Of course, this is true with all stock market investments, which is why stock selection is a crucial component of selling covered calls.
The Snider Investment Method uses very rigid parameters to select stocks. You can learn more here. Your guidelines for choosing stocks should be rigorous too. The goal is the identify the quality stocks.
The second risk you should think about is that covered calls can actually limit your upside potential. Think about it, you’re locking yourself into selling at, say, $60 per share regardless of what that stock is trading at. It could be trading at $65 – it doesn’t matter, because you are obligated to sell at $60.
Your Next Steps
You’ve taken a sneak peak at one of the best option trading strategies used today to generate income from your portfolio. We’ve defined what selling a covered call is, what it does, it’s benefits and risks, and why it’s a great move for increasing your portfolio income in retirement. Whether you’re a complete beginner, or experienced investor, you can learn this option trading strategy, relatively easily and quickly.
If you’re interested in learning more, sign up for our free e-courses to learn the basics, and check out our covered call screener to find opportunities in today’s market. Or, if you’re interested in a hands-off approach, contact us to learn more about our asset management services that can help you generate more income without any extra effort.