“Nothing in life is free!” Many of us learned that expression at an early age, and I strongly agree with it. If anyone promises me free money, I run the other way. That said, if you own individual stocks such as JPMorgan (JPM) or Johnson & Johnson (JNJ), I regularly recommend an options strategy that’s as close to free money as you can find—using covered calls to generate income.
I will tell any investors, whether they’re my parents or friends at a cocktail party, that they need to use options to create extra yield in their portfolio.
A covered call is a strategy in which the trader holds a long position in a stock and sells a call option on the same stock in an attempt to generate income.
For example, if I own 100 shares of McDonald’s (MCD), I could sell one call against my stock position. When I sell that call, I receive compensation because I’m giving up potential upside on my stock position.
And if you sell a covered call on dividend-paying stocks, you can continue to collect your dividend (as long as shares aren’t called away, which can sometimes happen early if you’re simultaneously close to the strike price, expiration date of the contract, and ex-dividend date of the stock).
The reason I consider covered calls close to “free money” is that selling a call against a new or existing holding does not add risk to your portfolio, it removes it!
When you receive call premium you reduce the maximum loss you can take on a stock position, in exchange, you limit some of your upside for the life of the call contract.
Creating Income with Covered Calls
Let’s take a look at a scenario of how a covered call strategy works using dividend stocks. Many savvy investors use covered calls on high-dividend stocks to gain two sources of income while holding the stock. For this exercise, I will look at how General Motors (GM) would have performed in 2015 with a covered call strategy. That time period was selected for this exercise to show that you can still generate solid returns, even if the stock price doesn’t budge (as was the case with GM in 2015).
General Motors closed at 35 on December 31, 2014. For this exercise, I theoretically bought 500 shares of GM on the first trading day of 2015, January 2. At the same time I bought the stock, I sold five 2016 January 40 Calls for $1.50 (Each option is equivalent to 100 shares, so when a trader sells one call for $1.50, he actually collects $150.)
Let’s break down the scenarios of this trade:
My capital outlay on the stock trade was $17,500 for the purchase of 500 shares of GM at 35.
I collected $750 with the sale of five January 40 Calls. (The math behind this is 5 x $150 = $750.) The $750 is immediately credited to my account.
I would have collected $552 from the dividend payment on my 500 shares of stock over the course of the year.
If GM had closed unchanged from my original purchase price of 35 on the call’s expiration on January 15, 2016, I would have collected the $750 from the sale of the calls and the $552 from the four dividends and I would have continued to hold my 500 shares of GM. Between the call sales and the dividends, I would have collected an extra $1,302, for a yield of 7.44%.
The 7.44% yield would have been created because the stock closed unchanged on the year.
If GM closed at 40 or above, I would have made $2,500 in stock appreciation on my 500 shares, plus the $750 I received for selling the January 40 Calls and the four dividends of $552.
However, because I sold January 40 Calls, if GM had closed above 40 on the expiration of the calls, I would have been taken out of my stock position by the owner of the calls, who has the right to buy the stock from me. But if that had happened, between the stock appreciation, the call sales and the dividend, I would have made $3,802—a profit of 21.72%.
Using covered calls to generate income is an outstanding way to create extra yield if you hold individual stocks. And executing the strategy on dividend stocks is a way to get a bigger potential yield. While a covered call limits the potential upside if the stock makes a big move, for many investors, yields of 7.44%, and 21.72% in stocks like GM are home runs.
Selling options is a key component of our strategy at Cabot Profit Booster where our subscribers receive the best growth stock recommendations coupled with income-boosting options trades. If you’re looking to juice your portfolio’s income-generating potential, subscribe today!
