With a traditional approach to investing, you buy a stock with the expectation that its price will rise, allowing you to sell it for a profit in the future. The focus is the stock’s capital appreciation potential. But how does this approach fare when your primary goal is portfolio income?
The answer largely depends on stock market conditions. In bull markets, a classic buy-and-hold strategy can work quite well. But in steep market declines, a capital approach to investing can present significant challenges creating consistent, livable income.
Fortunately, there are other strategies that have proven to be both powerful and useful ways to generate a portfolio paycheck. At the top of our list: covered calls.
Writing (selling) covered calls is an income-producing option trading strategy that allows more flexibility for short-term income and long-term capital gains, while also offering protection against a volatile market.
But if you’ve never written a covered call before, or if you have, but you’re looking to gain a higher yield, there are a few things you need to know first.
What to Know About Calls and Options
A covered call is an options strategy designed to turn stocks into income-producing assets. You begin by owning shares of a stock, then sell call options on those shares to generate immediate cash. In return for that income, you agree to sell the stock at a set price (the strike price) if it rises high enough.
The buyer doesn’t have to buy the stock, but he has the right to. Even if he doesn’t buy it, the seller keeps the money they were paid when they sold their option.
The option price, which can change as the stock moves in the market, is the price the option is bought or sold for. As with a stock, there are two prices: “Bid” and “Ask.” The buyer and seller agree on a strike price when the option is bought/sold.
For example, if you owned a stock currently trading around $43 per share, you could sell a call option that expires in June and has a strike price of $45. Two things can happen:
- If your stock stays below $45 before the call expires (in June), you keep both the stock and the amount you sold the call for (which is called the premium).
- If the stock rises above $45 before the call expires, the buyer exercises the call, buying the stock from you for $45 per share. You get the money from the sale of the stock and the premium, but you no longer own the stock.
A buyer has the right to exercise their option up until the expiration date. If that happens, meaning the stock is called away, the shares are automatically delivered to the buyer. Monthly options typically expire on the third Friday of every month.
As a general rule when you buy a call option, you need the share price to move higher in order to make money and you also need it to happen within a relatively short timeframe. With each day that passes, options decay in value, which is bad for the buyer (but great for the seller).
This makes call options a strong choice for sellers looking to make a profit off of stocks they already own.
How to Write Covered Calls
If you already own stocks, writing covered call can boost your yield and lower your risk.
To write a covered call option, you:
- Choose a stock you already own and for which there is an options market (alternatively you can buy shares of stock you want to own)
- Decide how many calls you want to write (sell)
- Pick a strike price
- Pick an expiration date
Keep in mind that each call gives its buyer the right to buy 100 shares of a stock. Conversely, it gives its seller an obligation to sell shares of a stock. You must own at least 100 shares of a stock to write a call.
If you sell calls expiring soon, there’s less risk that your stock will rise above the strike price and get called away, but there’s a trade-off. If you sell longer-dated calls, your premium will be higher. Make sure you understand the risk with short-term and long-term expiration dates and how they affect your premium and stock ownership once or if the call is sold.
Some Advice for Better Yields
If you want to make sure that your premiums have a higher yield, here are a few rules of thumb:
- Write covered calls on stocks with dividends
- Sell at a strike price above the current market price of the stock
- Select near-term expirations and sell them consistently
- Choose an underlying stock with an at-the-money option (the strike price is similar to the underlying stock’s price)
It’s important to choose the right stocks. Stocks from financially heathy companies that are also heavily traded can oftentimes be good choices.
One warning: Avoid selling call options without owning the underlying stock. Only sell covered calls for stocks you own. If you don’t own the stock, then the call sale is “uncovered” or “Naked.” (This strategy is highly speculative and significantly riskier.)
Also be wary of any taxes that need to be paid after a sale. Option income is typically considered a short-term capital gain, which is currently taxed as ordinary income.
Final Thoughts
Writing covered calls can be an excellent strategy for investors who want to use stocks they already own (or want to own) to generate consistent income.
If you’re interested in stock selection or wanting to learn more about covered calls, be sure to check out our free courses on covered calls and stock options. Since 2002, we’ve taught thousands of investors how to write covered calls and implement the Snider Investment Method on their portfolio.